The federal tax consequences for Series EE and I US Savings Bonds are anything but straightforward. Although interest on these bonds is fully exempt from state and local taxes, federal tax treatment varies depending on who owns the bonds and, in some cases, how they are used.
Here are four common scenarios retirees may encounter as to how and when bond interest is taxed.
Buyers of EE or I savings bonds have a choice when purchasing the bonds. They can pay taxes annually on the interest earned or defer the tax bill until the very end. Most people choose the latter. They report the interest as taxable income on their Form 1040 for the year the bonds mature or when cashed, whichever comes first. Defering tax on the full amount of interest accrued for up to 30 years may seem like a great idea until you get the tax bill for three decades of interest. Worse yet, paying tax all at once could push you into a higher tax bracket, making the bill even more expensive than it should be.
Many grandparents buy savings bonds for their grandchildren. As long as the bonds are titled in the grandchild’s name, the interest is usually reportable by the grandchild, who can choose to defer paying tax on the interest or report it annually., like any other bond. For bonds issued in the name of co-owners, such as a parent and child or grandparent and grandchild, interest is generally taxable to the co-owner who paid the obligation. This is true even if the other owner redeems the bond and keeps the proceeds.
Giving bonds you already own to a child, grandchild, or someone else doesn’t get you off the hook with Uncle Sam for owing money on previously untaxed interest. If the bonds are reissued in the name of the donation recipient, you are still taxed on all that interest for the year the donation is made. The same is true if you donate a savings voucher to charity. If, on the other hand, you have declared taxable interest each year, there is no big federal tax impact to come when you make the donation.
What if you inherit EE or I savings bonds that have not yet reached their maturity date? Who is taxed on accrued interest that was not taxed because the original owner deferred the interest? It depends. The executor of the estate may choose to include in the deceased’s final tax return any pre-death interest earned on the bonds. If so, the beneficiary only reports post-death interest on Form 1040 when the bonds mature or are redeemed, whichever comes first. If the executor does not include the interest income in the original owner’s final return, the beneficiary will have to tax all interest on the bond after the bond matures or is paid off.
One way to avoid having to pay tax on bond interest is to cash out your EE or I bonds before maturity and use the proceeds to pay for your education. If you follow this set of rules, interest will not be taxable:
- You must have acquired the bonds after 1989 when you were at least 24 years old.
- The bonds must be in your name only.
- Bonds must be redeemed to pay for tuition and fees at an undergraduate, graduate, or vocational school for you, your spouse, or your dependent, such as a child reported on your tax return. Bonds can also be redeemed to pay for a computer that you, a spouse, or a dependent use for school. Room and board costs are not eligible, and grandparents cannot use this tax break to help someone, such as a grandchild, who is not declared as a dependent.
- Education fees must be paid using the proceeds of the bonds in the year they are repaid.
- High incomes are not eligible. The interest exclusion begins to gradually disappear for joint filers with modified adjusted gross income of more than $ 124,800 (more than $ 83,200 for other filers) and ends when the modified AGI reaches $ 154,800 (98 $ 200 for other declarants).
Note that if the product of all EE and I bonds cashed in during the year exceeds the qualifying education expenses paid in that year, the amount of interest you can exclude is reduced proportionately.