Dear College Money Guru,
I have saved many bonds through the years for my son. Now that he is 18 and will be entering college in the fall, I would like to know how to go about cashing in some of the bonds for educational expenses.

Can the bond money be used for books, lab fees or even housing in a dormitory? What exactly are the limits?

We already have the money for tuition through the Maryland Prepaid College Trust. How do we use these bonds so that we don't have to pay huge amounts in taxes? Or will we have to pay the taxes anyway?
-- Doreen

Dear Doreen,
First, you must be certain that your bonds qualify for the bond education exclusion. Make sure you can answer the following questions affirmatively:

5 key questions

• Are they I bonds or Series EE U.S. savings bonds purchased after 1989? • Were you at least 24 when you purchased them and were they purchased in your name (not your child's)? • Does your 18-year-old qualify as your dependent? • Will your 2008 adjusted gross income, including interest on redeemed bonds, be less than $100,650 if you are married or a surviving spouse, or less than $67,100 if you are single? • If married, do you file a joint tax return?

If you can answer "yes" to all of those questions, you should be eligible to redeem your savings bonds and exclude the interest from your income. However, the exclusion applies only to the extent that your bond proceeds do not exceed the qualified higher education expenses of your dependent child (or of yourself, or your spouse).

If you answered "no" to only the question about income, and your income is below $130,650 (joint) or $82,100 (single), you can exclude only part of the interest using a phase-out computation.

Unfortunately, qualified higher education expenses for purposes of the education bond exclusion include only tuition and mandatory fees -- not room, board, books, supplies or equipment.

Furthermore, your son's tuition and fees cannot be counted for the education bond exclusion to the extent they are paid from the Maryland Prepaid College Trust, or from any other 529 plan or Coverdell education savings account.

However, all is not lost. If you meet all other requirements listed above, you can increase the total qualified higher education expenses by the amount of any contributions you make this year to a 529 plan for your son.

In other words, open an account with a 529 savings program and contribute at least the amount you receive from the redemption of your bonds. The interest on the bonds now gets excluded from your income.

You will need to inform the 529 plan at the time of your contribution that the money is coming from the tax-free redemption of qualified education bonds.

When choosing a 529 plan, consider Maryland's College Investment Plan. It's a good one, and you will even qualify for a Maryland state income tax deduction.

With the money in your 529 savings program, you will be able to pay for the qualified higher education expenses (including room and board, and books, supplies, and equipment) that are not paid by your prepaid college trust fund.

The withdrawals come out tax-free to the extent they qualify under the rules for 529 plans. It won't matter if your child is still your dependent.

I suggest you wait until 2009 -- at the earliest -- before tapping the 529 account that includes the proceeds from your bond redemptions. If you withdraw from the account in the same year you redeem the bonds, the IRS may try to apply the law in such a way that your bond interest becomes taxable.

You can find more guidance (but not on that particular question) in IRS Publication 970. You will also find a lot of useful information about savings bonds and the education bond exclusion at the TreasuryDirect Web site.

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