How to Avoid Paying Taxes on Savings Bonds
Options to redeem savings bonds without paying tax on the interest
Many baby boomers and retirees prefer to invest in savings bonds because they're safe, practical investments, but bonds don't earn interest forever. They eventually mature, and the Internal Revenue Service requires that you pay income tax on the interest they've earned.
When that time comes, the Internal Revenue Service (IRS) offers choices for how you redeem your bonds and pay tax on your interest. One of them can help you avoid paying any tax on the interest at all.
Savings Bonds Basics
Series EE bonds are the most common type of bonds issued by the U.S. Treasury. They earn interest for 30 years if you keep them that long, but you have to hold them for at least one year or you'll forfeit your investment. EE bonds come with a fixed interest rate of just 0.10%, but they're paying a variable rate of 1.57% as of 2019 if you purchased them between May 1997 and April 2005.
Federal law allows taxpayers to purchase up to $10,000 per type of bond each year. This increases to $20,000 if you’re married and your spouse wants to buy, too. You also can purchase an additional $5,000 if you use your tax refund to buy paper Series I bonds.
When Savings Bond Interest Is Taxable
Even at these interest rates, your bonds will earn some amount of interest each and every year, and the IRS wants its share of that money. But you have a choice for when to pay this tax with EE and I bonds.
You can defer the interest until you redeem the bond or it matures, whichever happens first, or you can pay taxes on the interest yearly. Unfortunately, you can't change your mind at a later date—this is a one-time election. And if you decide to defer the interest, you must pay the associated taxes—as much as 30 years’ worth unless you redeem the bonds sooner—all at once in that year.
There's one more catch. You must treat all your EE bonds the same way. You can't defer the interest on one and pay yearly on others.
Bond interest is only taxable at the federal level. You can avoid state and local taxes on the interest your bonds earn, which might make them an attractive investment choice for taxpayers who live in states with high income tax rates.
The Education Tax Exclusion
So is there a way out of all this? Yes, for some taxpayers.
You can avoid paying taxes on interest earned by Series EE and Series I savings bonds when you redeem them if you use the money toward qualified higher education costs for yourself, your spouse, or any of your dependents. This comes with a number of qualifying rules:
- Series EE and I bonds must have been issued after 1989.
- The owner of the bonds must have been at least 24 years old on the first day of the month in the year in which they were issued. If you own them and meet this age requirement, you can redeem them tax-free to pay for a child’s education costs even if that child not yet 24.
- You must pay the education costs in the same year you redeem the bonds, and only certain costs are covered: tuition, fees, some books, and some equipment such as a computer that might be required for a certain course. Room and board and recreational or sports fees don't qualify.
- You must use all the proceeds of your redeemed bonds, both principal and interest, to pay for education costs. If the proceeds amount to more than you owe the school, the portion of the interest that would otherwise be tax-exempt is prorated.
- The school must be one with a student aid program with the U.S. Department of Education.
- You must file a joint tax return with your spouse if you're married.
- You must meet income requirements.
You can also direct all funds from your redeemed bonds to a Coverdell Education Savings Account if no one in your family is quite ready to head off to college just yet.
Income Requirements for the Education Tax Exclusion
Not every taxpayer can make use of the education tax exclusion. One final rule involves your modified adjusted gross income (MAGI) for the year when you use the bonds to pay for education costs.
When your MAGI reaches a certain threshold, only a portion of your bond interest is excluded from taxation. If your income reaches a second threshold, you can't claim the exclusion at all. Any interest earned by the bonds counts toward your MAGI.
As of 2019, a single taxpayer can earn up to $81,100 and still claim the full exclusion. The limit increases to $121,600 if you're married. The exclusion then begins to phase out, and it’s eliminated entirely for single taxpayers with MAGIs of $96,100, or $151,600 for married taxpayers filing jointly.
Reinvesting to Avoid Tax on Savings Bond Interest
Up until 2004, it was possible to continue deferring interest on bonds even if your Series EE bonds matured. You could effectively reinvest that money, redeeming the bonds then using the proceeds to purchase Series HH bonds. You could then continue deferring the interest on the principal. However, the U.S. Treasury no longer issues Series HH bonds so this option is no longer available.
Avoid Tax on Inherited Savings Bonds
You might have a different option if you inherit the bonds, however. The executor of the deceased's estate can redeem the bonds, pay the taxes on the interest from the estate, then have them reissued to you. This allows you to avoid paying tax on interest that was earned during the decedent’s lifetime.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Treasury Direct. "Series EE/E Savings Bonds Tax Considerations." Accessed Apr. 10, 2020.
Treasury Direct. "May 1997 through April 2005 (EE Bond Rates and Terms)." Accessed Apr. 10, 2020.
Treasury Direct. "Series EE Savings Bonds." Accessed Apr. 10, 2020.
Treasury Direct. "Treasury Department Sets Online Savings Bond Annual Purchase Limit at $10,000 per Series." Accessed Apr. 10, 2020.
Treasury Direct. "Tax Considerations for I Bonds." Accessed Apr. 10, 2020.
Internal Revenue Service. "IRS Publication 500 - Reporting Options for Cash Method Taxpayers." Accessed Apr. 10, 2020.
Treasury Direct. "Education Planning - Education Tax Exclusion." Accessed Apr. 10, 2020.
Ameriprise Financial. "Your Guide to Coverdell Education Savings Accounts," Page 7. Accessed Apr. 10, 2020.
Internal Revenue Service. "Form 8815 - Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989," Pages 3-4. Accessed Apr. 10, 2020.
Internal Revenue Service. "IRS Publication 970 - Tax Benefits for Education," Page 63. Accessed Feb. 20, 2020.
Treasury Direct. "Series HH Savings Bonds." Accessed Apr. 10, 2020.
Internal Revenue Service. "IRS Publication 559 - Survivors, Executors, and Administrators," Page 11. Accessed Apr. 10, 2020.