How to Avoid Paying Taxes on Savings Bonds

Savings bonds are one of the safest ways of long-term investment while earning interest. US treasury issues savings bonds to raise capital. By buying bonds, investors give loans to the United States government with an agreed interest at a predetermined date.

The purchase limit for savings bonds for individuals is $10,000 whereas, it is $20,000 for married couples. There are two types of savings bonds in the USA. They are,

• Series I bonds – earn fixed interest and protect investors from inflation.
• Series EE bonds – earn interest for 30 years and do not protect investors from inflation.

Investors have two options to report the interest earned from savings bonds. They are:

• Defer to report the interest earnings till the redemption or maturity of the savings bonds.
• Reporting the interest earnings every year and paying taxes annually.

In order to avoid paying tax on interest earned from savings bonds, basically,

• Bonds should be issued after the year 1989.
• The owner should be aged above 24 at the time of bonds issued.

This article explains how to avoid tax on interest in detail.

Quick Insights

When savings bonds interest is taxable?

Savings bonds interest comes under more than one type of tax as below:

• Federal income tax
• Federal estate or gift or excise tax
• State estate or inheritance tax

State and local taxes don’t apply to savings bonds.

How much an investor should pay tax depends on, the type of bond he purchased, how long he holds it, and who owns it. Interests on savings bonds are subject to different types of taxes. One can defer the savings bond interest till redemption or maturity.

How to avoid taxes on savings bonds?

The big question is, how do I avoid paying taxes when cashing in savings bonds? One can avoid paying taxes on the earned interests on series EE and series I savings bonds. One should meet the below criteria to avoid taxes:

1. Education exclusion

Higher education expenses should be spent the same year of the bonds redeemed. Using the interest earned for certain allowed higher education expenses will keep you from paying taxes. Higher education expenses may include tuition fees, qualified books, and a few types of equipment such as laptops.

2. Rolling over to education savings account

Rolling the funds of savings bonds to the college savings accounts is another option for avoiding tax. 529 college savings plan and Coverdell education savings accounts are a few of the college savings accounts to roll on to. These savings accounts can be contributed to a child up to his/her 18^th birthday only.

3. Gifting the savings bonds

Gifting bonds to a beneficiary with a lower income/tax bracket will help in taxation of a lower rate. The beneficiary can be a child under a certain age, in which the tax comes under “kiddie tax” rules.

4. Tax-deferred accounts

One can prefer to hold the savings bonds in tax-deferred accounts, such as IRA (Individual Retirement Account). Deferring taxes until the maturity of bonds potentially lowers the tax at that time of redemption.

5. Redeeming in time

It is very much necessary to wait for the right time to redeem the savings bonds. Most of the tax advisors suggest going for redemption of the savings bonds in the year when the income is low. This would help in lowering the tax rate on the interest earned.

How to avoid taxes on inherited savings bonds?

Bonds that can be passed down to the beneficiaries are called inherited savings bonds. They are taxable and are subject to federal estate tax. One can either defer taxes on inherited savings bonds or avoid them in certain accepted circumstances.

In order to find your tax liability, it is important to know the value of the inherited bond, whether it is still earning interest, when the bond will mature, and also whether any income tax was already paid towards the interest. After knowing that, you can either cash out the bond or reissue it in your name.

If the original bond owner deferred the interest, then you will be obviously responsible for paying the taxes towards the interests earned. You can get the estate to pay the tax on inherited savings bonds. If the inherited bonds are passed on to multiple beneficiaries, it is important to get everyone’s agreement to get the estate to pay the tax.

It is also essential to save the previously paid interest documents so that you can easily avoid issues relating to tax when you pass on those inherited bonds to your beneficiaries. To avoid paying tax for inherited bonds, one should qualify for the education exclusion. For this, you should:

Cash out and use the funds for higher education expenses. (There are allowed expenses and qualified institutions to determine tax)

Inherit the series EE or I savings bonds that were issued after 1989.

Conclusion

Using the interest earned on savings bonds for qualified higher education costs is the most preferred way to avoid paying taxes. However, there are certain conditions to be eligible for tax exemption and the expenses need to be qualified under the federal tax regulations.