Retirees, Plan for the Tax Hit From Savings Bonds
The federal tax consequences for Series EE and I U.S. savings bonds are anything but straightforward. Here's how interest from savings bonds is taxed in four common situations for retirees.
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.
When You're the Owner of the Savings Bond
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.
What to Do If the Savings Bond Is a Gift
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.
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.
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.
