The federal tax consequences for Series EE and I U.S. savings bonds are anything but straightforward. Although the interest on these bonds is fully exempt from state and local taxes, the federal tax treatment varies depending on who owns the bonds and, in some cases, how they are used.
Here are four common scenarios that retirees may encounter for how and when the bond interest is taxed.
Buyers of EE or I savings bonds have a choice when they acquire the bonds. They can pay tax each year on interest earned or defer the tax bill to 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 they're cashed in, whichever happens first. Deferring tax on the full amount of accrued interest for up to 30 years may sound like a terrific idea until you get the tax bill for three decades worth of interest. Worse, taking the tax hit all at once could push you into a higher tax bracket, making the bill even more expensive than it needed to be.
Many grandparents buy savings bonds for their grandkids. Provided the bonds are titled in the grandchild's name, the interest is generally reportable by the grandchild, who can choose to defer paying tax on the interest or report it annually, the same as any other bondholder. For bonds issued in the name of co-owners, such as a parent and child or grandparent and grandchild, the interest generally is taxable to the co-owner who paid for the bond. This is true even if the other owner redeems the bond and keeps the proceeds.
Giving away bonds you already own to a child, grandchild or other person doesn't get you off the hook with Uncle Sam for owing money on previously untaxed interest. If the bonds are reissued in the gift recipient's name, you are still taxed on all that interest for the year the gift is made. The same applies if you donate a savings bond to charity. If, on the other hand, you reported the interest as taxable each year, there's no big federal tax hit coming when you make the gift.
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Who Pays the Taxes If You Inherit a Savings Bond?
What if you inherit EE or I savings bonds that haven't yet reached maturity? Who is taxed on the accrued interest that went untaxed because the original owner deferred the interest? It depends. The executor of the estate can choose to include on the decedent's final income tax return all pre-death interest earned on the bonds. If so, the beneficiary reports only post-death interest on Form 1040 when the bonds mature or are redeemed, whichever comes first. If the executor doesn't include the interest income on the original owner's final return, the beneficiary will owe taxes on all bond interest once the bond matures or is redeemed.
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Using the Savings Bond to Pay for College Tuition
One way you might avoid owing taxes on the bond interest is to cash your EE or I bonds before maturity and use the proceeds to pay for college. If you meet this set of rules, the interest won't be taxable:
You must have acquired the bonds after 1989 when you were at least age 24.
The bonds must be in your name only.
The 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 claimed on your tax return. The bonds can also be redeemed to pay for a computer that you, a spouse or a dependent uses for school. Costs for room and board aren't eligible, and grandparents can't use this tax break to help someone, such as a grandchild, who isn't claimed as their dependent.
The educational expenses must be paid using the bond proceeds the year that they are redeemed.
High earners don't qualify. The interest exclusion begins to phase out for joint filers with modified adjusted gross incomes of more than $124,800 (more than $83,200 for other filers) and ends when modified AGI hits $154,800 ($98,200 for other filers).
Note that if the proceeds from all EE and I bonds cashed in during the year exceed the qualified education expenses paid that year, the amount of interest you can exclude is reduced proportionally.
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Joy Taylor
Editor, The Kiplinger Tax Letter
Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and editsThe Kiplinger Tax Letterand contributes federal tax and retirement stories tokiplinger.comandKiplinger’s Retirement Report. Her articles have been picked up by theWashington Postand other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.
One way you might avoid owing taxes on the bond interest is to cash your EE or I bonds before maturity and use the proceeds to pay for college. If you meet this set of rules, the interest won't be taxable: You must have acquired the bonds after 1989 when you were at least age 24. The bonds must be in your name only.
You can report the interest each year you earn it or when you cash the bond. You will report it on Schedule B of your 1040. You can avoid these taxes by using the money for qualified higher education expenses.
The interest on EE bonds isn't taxed as it accrues unless the owner elects to have it taxed annually. If an election is made, all previously accrued but untaxed interest is also reported in the election year. In most cases, this election isn't made so bond holders receive the benefits of tax deferral.
16. How are savings bonds taxed? Savings bond interest is exempt from state and local income tax. Savings bond interest is subject to federal income tax; however, taxation can be deferred until redemption, final maturity, or other taxable disposition, whichever occurs first.
If the executor doesn't include predeath interest on the decedent's final return, then the beneficiary owes federal income tax on all pre- and post-death interest on the earlier of the bond's maturity or redemption.
If you have paper savings bonds, you can fill out the appropriate form and mail it and the bonds you want to cash to the Treasury Retail Securities Services — the address is listed on FS Form 1522. Additionally, you may be able to cash your paper savings bonds at your bank or credit union.
If you cash a paper savings bond at a local bank, that bank is responsible for giving you a 1099. If you cash a paper savings bond by mailing it to Treasury Retail Securities Services, we mail you a 1099 by January 31 of the following year. (You can call us for a duplicate statement, if needed, beginning February 15.)
Interest from EE U.S. savings bonds is taxed at the federal level but not at the state or local levels for income. The interest that savings bonds earn is the amount that a bond can be redeemed for above its face value or original purchase price.
In general, you must report the interest in income in the taxable year in which you redeemed the bonds to the extent you did not include the interest in income in a prior taxable year.
To defer taxes on CD interest until retirement, you can open a CD within a tax-deferred retirement account — whether it's an employer-sponsored plan or an IRA.
Series EE, Series E, and Series I bonds can be cashed at a local financial institution. Some of these transactions may have to be forwarded for further processing. Series HH and Series H bonds must be sent to one of the addresses shown at the bottom of the following page.
You can skip paying taxes on interest earned with Series EE and Series I savings bonds if you're using the money to pay for qualified higher education costs. That includes expenses you pay for yourself, your spouse or a qualified dependent. Only certain qualified higher education costs are covered, including: Tuition.
If the value of the bonds exceed $100,000 or the estate is being administered by a court, the personal representative (meaning the executor or administrator) of the estate can redeem the bonds by mailing evidence showing his or her appointment as personal representative, a certified copy of the owner's death ...
You can get your cash for an EE or I savings bond any time after you have owned it for 1 year. However, the longer you hold the bond, the more it earns for you (for up to 30 years for an EE or I bond). Also, if you cash in the bond in less than 5 years, you lose the last 3 months of interest.
A 3-month interest penalty will apply to bonds cashed before five years. Some older EE Bonds earn interest based on 5-year Treasury security yields or at a guaranteed minimum. The rate that Treasury announces each May and November is applied to a bond for the 6-month earning period.
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