How to Avoid Paying Taxes on Savings Bonds

Some options might help you avoid paying taxes on savings bond interest

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Savings bonds are one of those investments that seem to have been around forever. Many baby boomers and retired people still prefer them for the safe, practical investments that they are.

The problem with bonds is that they don’t earn interest forever. Eventually, they mature. At some point, the Internal Revenue Service will want you to pay income taxes on the interest they’ve earned, but the IRS provides you with a couple of options. One might allow you to avoid paying any tax on the interest at all.

Savings Bonds Basics

Series EE 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, and as a practical matter, you have to hold them for at least one year or you’ll forfeit your investment. EE bonds sold today come with a paltry fixed interest rate of just .10 percent, but if you purchased them between May 1997 and June 2004, these are paying a variable rate of 1.07 percent as of 2017.

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, and you can purchase an additional $5,000 if you tell the IRS that you want to use your tax refund to buy old-fashioned paper Series I bonds.

When Bond Interest Is Taxable

Even at these interest rates, your bonds will earn some each and every year and the IRS wants its share of that money. But here’s a bit of good news—bond interest is only taxable at the federal level. You’ll dodge state and local taxes on the interest your bonds earn, which might make them seem like a more attractive investment vehicle for taxpayers who live in states with high income tax rates.

As for federal taxes, you have a choice 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 and go back and forth over the course of 30 years. It’s 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.

And there’s one more catch. You must treat all your EE bonds the same way. You can’t defer the interest on this one and that one, then pay yearly on a handful of others.

The Education Tax Exclusion

So is there a way out of all this? Maybe for some taxpayers.

The IRS lets you 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.

Of course, doing this comes with a number of qualifying rules.

  • If you have Series EE bonds, they 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. But if you own them and you meet this age requirement, you can redeem them to pay for your child’s education costs even if he’s 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 what you owe the school, the portion of the interest that would otherwise be tax-exempt is prorated.
  • The school must be one with which the U.S. Department of Education has a student aid program. 
  • You must file a joint tax return with your spouse if you’re married.

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.

The Modified Adjusted Gross Income Rule

Not every taxpayer can make use of the education tax exclusion. One final rule involves your modified adjusted gross income 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—it’s not just income you earn.  

As of 2018, a single taxpayer can earn up to $79,700 and still claim the full exclusion. The limit increases to $119,500 if you’re married. The exclusion then begins to phase out, and it’s eliminated entirely for single taxpayers with MAGIs of $94,700, or $149,550 for married taxpayers.

What If You Reinvest?

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. Unfortunately, the U.S. Treasury no longer issues Series HH bonds so this option is no longer available.

You might have a different option if you inherit the bonds, however. If you can convince the executor of the estate to work with you, she can redeem the bonds, pay the taxes on the interest from the estate, then have them reissued to you. This would at least let you avoid paying taxes on interest that was earned during the decedent’s lifetime.