I have $7,000 in EE savings bonds that I'd like to use for college bills. How do I make sure I get the full tax break?

A helping of EE bonds sure comes in handy at this time of year, when tuition bills start arriving in mailboxes around the country. That's because, when used for educational expenses, the interest earned on series EE bonds purchased after 1989 is excluded from all taxes (federal, state and local). That's a great deal considering that interest earned on other bonds is taxed as ordinary income, at rates that can run as high as 35%.

So how does one claim the break? It's all done on the tax return, says Peter Hollendach, a spokesman with the U.S. Treasury Department in Washington, D.C. Just cash the bonds at your bank and pay your child's tuition bill as you normally would. Come tax-time, file IRS form 8815, Exclusion of Interest from Series EE and I Savings Bonds, to claim the exemption. For personal records, fill in and keep Form 8818, which requires that the bond-holder record the serial number, issue date and face value of each bond sold. This information should be available from the bank where the bonds were cashed, says Hollendach.

Keep in mind that certain eligibility criteria must be met. For starters, there are income restrictions. For tax-year 2004, the break phases out for those with modified adjusted gross income (MAGI) between $89,750 and $119,750 for married couples filing jointly, and $59,850 to $74,850 for single tax filers. Married couples filing separately aren't eligible for the exclusion.

Next hurdle: The bonds must be used to pay for qualified educational expenses, which include tuition and fees, but not housing and books, says Hollendach. (For specific details, read IRS Publication 550.) In addition, the amount of qualified expenses is reduced by any scholarships and financial aid received by the student, as well as any other educational tax credits or deductions claimed by the parent. (In other words, if a parent claims the $4,000 tuition deduction and the $1,500 Hope Scholarship credit, the amount of qualified education expenses to be paid with EE bonds is reduced by $5,500.)

Also, if the bondholder doesn't use all of the bonds for qualifying expenses, the tax break is pro-rated. So if, say, one sells bonds with a $5,000 face value and $2,000 interest payment, but uses only half, or $3,500, for the tuition bill, then only half the interest, or $1,000, will be tax-free.

Another important restriction: The tax break applies only to expenses incurred during the tax year in which it is claimed, Hollendach notes. So before cashing in $7,000 worth of bonds, make sure all the proceeds can be spent on qualified expenses paid in 2004. For 2005 expenses, wait until 2005 to cash the bonds. "You're better off holding the bonds a little bit longer and earning more interest, anyway," Hollendach says.

And here's a final tip: Be sure to sell the bonds in the beginning of the month, as opposed to the end, since interest is accrued on the first of each month. (If you redeem a bond on Aug. 31, none of the interest earned in August will be included in its value.)

Don't meet the criteria for tax-free treatment? Then you don't need to fill out Form 8815, says Nancy Mathis, a spokeswoman for the IRS. Instead, report the interest income on Schedule B when it comes time to file.

For more on Series EE Savings bonds, visit the Bureau of Public Debt's Web site.