It depends on the type of government bond.
Tax on interest on U.S. savings bonds can be paid incrementally each year, but most savings bonds owners elect to pay taxes in the year when the bonds are redeemed or reach full maturity (e.g., 30 years from the date they were issued). You are 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.
1. You pay qualified education expenses for yourself, your spouse, or a dependent for whom you claim an exemption on your income tax return.
2. Your modified adjusted gross income (MAGI) is less than $86,100 in 2011 ($136,650 if married filing jointly or you are a qualifying widow[er]).
3. Your filing status is not married filing separately.
Qualified U.S. savings bonds must be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners). Qualified education expenses include the following items you pay for either yourself, your spouse, or a dependent for whom you claim an exemption.
1. Tuition and fees required to enroll at or attend an eligible educational institution. Qualified education expenses do not include expenses for room and board or for courses involving sports, games, or hobbies that are not part of a degree or certificate-granting program.
2. Contributions to a qualified tuition program (QTP).
3. Contributions to a Coverdell education savings account (ESA).
Municipal bonds are tax-exempt, so no federal income tax is owed. Municipal bonds may also be exempt from state and/or local income taxes if issued by the buyer's state and/or city of residence.
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