• Explanation

In general, under the all-inclusive approach to income, interest earned by a taxpayer is taxable. However, the IRC does provide certain statutory exclusions and exceptions. For instance, interest on U.S. state and local (ie, municipal) bonds is specifically excluded. However, there is no statutory authority to exclude interest earned on federal Treasury bills or interest earned on tax refunds.

Interest on Series EE bonds may be deferred until the bond is redeemed. Series EE bond interest is excluded if the proceeds are used to pay higher education tuition and fees for the taxpayer, spouse or dependent. The bond must be purchased by the taxpayer or spouse and the buyer must be at least 24 years old. Room and board are not qualified expenses (Choice A). Therefore, the taxpayer's gross income is $2,550.

(Choice C) Income of $4,050 incorrectly assumes municipal interest is taxable and that Treasury bill interest is excluded.

(Choice D) Income of $5,050 incorrectly assumes all interest is taxable.

Things to remember:
Under the all-inclusive approach to income, interest earned by a taxpayer is taxable. There must be statutory authority provided in the IRC for a taxpayer to exclude an item from gross income (eg, municipal bond interest). Interest on Series EE bonds is deferred until the bond is redeemed and may be excluded if used for higher education tuition.