Income limits for exclusion reduction increased. . For 2006, the amount of your interest exclusion is phased out (gradually reduced) if your filing status is married filing jointly or qualifying widow(er) and your MAGI is between $94,700 and $124,700. You cannot exclude any of the interest if your MAGI is $124,700 or more. For 2005, the limits that applied to you were $91,850 and $121,850. For all other filing statuses, your interest exclusion is phased out if your MAGI is between $63,100 and $78,100. You cannot exclude any of the interest if your MAGI is $78,100 or more. For 2005, the limits that applied to you were $61,200 and $76,200. See Effect of the Amount of Your Income on the Amount of Your Exclusion, later.

Generally, you must pay tax on the interest earned on U.S. savings bonds. If you do not include the interest in income in the years it is earned, you must include it in your income in the year in which you cash in the bonds.

However, when you cash in certain savings bonds under an education savings bond program, you may be able to exclude interest from income.

You may be able to cash in qualified U.S. savings bonds without having to include in your income some or all of the interest earned on the bonds if you meet the following conditions.

Qualified U.S. savings bonds.   A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners).

  The owner must be at least 24 years old before the bond's issue date. The issue date is printed on the front of the savings bond.

  

The issue date is not necessarily the date of purchase—it will be the first day of the month in which the bond is purchased.

MAGI when using Form 1040.   If you file Form 1040, your MAGI is the AGI on line 38 of that form figured without taking into account any savings bond interest exclusion and modified by adding back any:

1. Foreign earned income exclusion,

2. Foreign housing exclusion,

3. Foreign housing deduction,

4. Exclusion of income for bona fide residents of American Samoa,

5. Exclusion of income from Puerto Rico,

6. Exclusion for adoption benefits received under an employer's adoption assistance program,

7. Deduction for student loan interest,

8. Deduction for tuition and fees, and

9. Deduction for domestic production activities.

   Use the worksheet in the instructions for Form 8815, line 9, to figure your MAGI. If you claim any of the exclusion or deduction items (1)-(6) listed above, add the amount of the exclusion or deduction to the amount on line 5 of the worksheet. Do not add in the deduction for (7) student loan interest, (8) tuition and fees, or (9) domestic production activities. Enter the total on Form 8815, line 9, as your modified AGI.

  

Because the deduction for interest expenses attributable to royalties and other investments is limited to your net investment income, you cannot figure the deduction until you have figured this interest exclusion. Therefore, if you had interest expenses attributable to royalties and deductible on Schedule E (Form 1040), Supplemental Income and Loss, you must make a special computation of your deductible interest without regard to this exclusion to figure the net royalty income included in your modified AGI. See Royalties included in modified AGI under Education Savings Bond Program in chapter 1 of Publication 550.

If the total you receive when you cash in the bonds is not more than the adjusted qualified education expenses for the year, all of the interest on the bonds may be tax free. However, if the total you receive when you cash in the bonds is more than the adjusted expenses, only part of the interest may be tax free.

To determine the tax-free amount, multiply the interest part of the proceeds by a fraction. The numerator (top part) of the fraction is the adjusted qualified education expenses you paid during the year. The denominator (bottom part) of the fraction is the total proceeds you received during the year.

Use Form 8815 to figure your education savings bond interest exclusion. Enter your exclusion on line 3 of Schedule B (Form 1040), Interest and Ordinary Dividends, or Schedule 1 (Form 1040A), Interest and Ordinary Dividends for Form 1040A Filers. Attach Form 8815 to your tax return.

The information is the same as in the previous example for Mark and Joan Washington, except they have a modified adjusted gross income of $108,500. In this example, they can exclude $1,377 (line 14 of Form 8815 shown on the next page) of interest in 2006.

They must pay tax on the remaining $1,623 interest ($3,000 total interest minus $1,377 excluded interest).