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 (IRS) requires that you pay income tax on the interest they've earned when that happens.
The IRS offers various options for redeeming your bonds and pay tax on your interest when that time comes, and 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 1.08% as of 2020 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 can purchase an additional $5,000 if you use your tax refund to buy paper Series I bonds.
When Savings Bond Interest Is Taxable
Your bonds will earn some amount of interest each and every year even at these rates, and the IRS wants its share of that money. But you have a choice as to when to pay it 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. This could be as much as 30 years’ worth all at once in the year you redeem.
There's one more catch. You must treat all EE bonds you hold the same way. You can't defer interest on one and pay yearly on the 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
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. But this option 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 isn't 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 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. The portion of the interest that would otherwise be tax-exempt is prorated if the proceeds amount to more than you owe the learning institution.
- 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 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 in which you use the bonds to pay for education costs.
Only a portion of your bond interest is excluded from taxation when your MAGI reaches a certain threshold. You can't claim the exclusion at all if your MAGI reaches a second threshold, and any interest earned by the bonds counts toward your MAGI.
As of 2020, a single taxpayer can earn up to $82,350 and still claim the full exclusion. The limit increases to $123,550 if you're married. The exclusion then begins to phase out, and it’s eliminated entirely for single taxpayers with MAGIs of $97,350, or $153,550 for married taxpayers filing jointly.
Reinvesting to Avoid Tax
It was possible to continue deferring interest on bonds even if your Series EE bonds matured through 2004. You could effectively reinvest the money, redeeming the bonds then using the proceeds to purchase Series HH bonds. You could then continue deferring the interest on the principal. The U.S. Treasury no longer issues Series HH bonds, however, so this option is no longer available.
Avoid Tax on Inherited Savings Bonds
You might have a different option if you inherit the bonds. 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.
NOTE: The Balance does not provide tax, investment, or financial 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. "May 1997 through April 2005 (EE Bond Rates and Terms)." Accessed Oct. 26, 2020.
Treasury Direct. "Buying Series EE Savings Bonds." Accessed Oct. 26, 2020.
IRS. "Using Your Income Tax Refund to Save by Buying U.S. Savings Bonds." Accessed Oct. 26, 2020.
Treasury Direct. "Tax Considerations for I Bonds." Accessed Oct. 26, 2020.
IRS. "IRS Publication 500 - Reporting Options for Cash Method Taxpayers." Accessed Oct. 26, 2020.
Treasury Direct. "Education Planning - Education Tax Exclusion." Accessed Oct. 26, 2020.
Ameriprise Financial. "Your Guide to Coverdell Education Savings Accounts." Page 7. Accessed Oct. 26, 2020.
This Matter. "Education Savings Bonds Program." Accessed Oct. 26, 2020.
Treasury Direct. "Series HH Savings Bonds." Accessed Oct. 26, 2020.