Bond taxes I in 9 common situations
As investors seek to protect their portfolio against rising inflation and stock market turbulence, many are turning to Series I savings bonds (I bonds). Currently, I bonds pay an interest rate of 9.62%. But don’t just focus on ROI. I bonds also have significant tax advantages for owners. Interest earned on I bonds is exempt from state and local tax, but owners can also defer federal income tax on accrued interest for up to 30 years.
Unfortunately, federal tax rules aren’t always straightforward. Therefore, the tax treatment varies depending on who owns the bonds, whether or not you give the bonds to someone else, and, in some cases, how they are used. Below are descriptions of how and when bond interest is taxed under federal law in nine common situations. Hopefully, if you’re trading these savings bonds, the information below will help lower your tax bill.
Buy I bonds for yourself
Buyers of I bonds have a choice when they buy the bonds. They can pay federal income tax each year on the interest earned or defer the tax bill until the end. Most people choose the latter. They report interest income on their Form 1040 for the year the bonds mature or when they are cashed, whichever comes first.
However, deferring tax on the full amount of accrued interest for up to 30 years might seem like a good idea until you get the tax bill for three decades of interest. Plus, taking the tax hit all at once can push you into a higher tax bracket, making the bill even more expensive than it should be.
Declare interest on the I Bonds you collect
If you cash I Bonds, you must report the interest on line 2b of Form 1040 and pay tax to the extent that you did not otherwise include interest income from a previous year. If you received $1,500 or more in interest during the year, you will also need to complete Schedule B.
If you used the bond proceeds to pay for higher education, some of the interest may be waived (see below). See instructions for Schedule B and Form 8815 on how to report any excluded interest.
Buy I bonds for someone else
Savings bonds make great gifts. But if you buy I bonds for someone else, the interest is declarable by that person, provided the bonds are titled in their name.
The beneficiary can choose to defer the payment of tax on the interest or declare it annually, like any other holder of I bonds.
I Bonds issued to co-owners
For I bonds issued in the name of co-owners, such as a parent and child or grandparent and grandchild, the interest is generally taxable to the co-owner whose funds were used to purchase the bonds. However, this co-owner can choose to defer the payment of tax on the interest or declare it annually. This is true even if the other co-owner redeems the bonds and keeps all the proceeds.
Offer bonds you own
Donating an I bond before maturity will accelerate the taxation of interest income. Giving bonds you already own to someone else doesn’t get you off the hook with Uncle Sam for owing money on previously untaxed interest. If the bonds are reissued in the name of the gift recipient, you are still taxed on all such interest in the year of the gift.
Donate I Bonds to charity
Donating an I Bond before its maturity to a charity during your lifetime will also accelerate the taxation of interest income. As with gifts to others, donating bonds you already own to your alma mater, favorite museum, or other charity does not allow you to avoid tax on previously untaxed interest. You are still taxed on all such interest in the year the gift is made.
Inherit Bonds I
If you inherit I bonds that have not yet matured, who is taxed on the accrued interest that was not taxed because the original owner deferred the interest? It depends. The executor of the deceased’s estate may choose to include any pre-death interest earned on the bonds on the deceased’s final tax return. If this is done, the beneficiary only reports post-death interest on Form 1040 when the bonds mature or are repaid, whichever comes first. If the executor does not include interest income on the deceased owner’s final federal income tax return, the beneficiary will have to pay taxes on all interest before and after death once the bond matures or is redeemed, whichever comes first.
Bond redemption I to pay for higher education
One way to avoid paying federal income tax on interest accrued on I bonds is to redeem the bonds before the maturity date and use the proceeds to help pay tuition or other graduate studies. But there are a lot of rules and hurdles to jump through in order to take advantage of that extra tax benefit. For instance:
- You must have purchased the bonds after 1989, when you were at least 24 years old;
- Bonds must be in your name only;
- Bonds are to be redeemed to pay for tuition and undergraduate, graduate, or professional school fees for you, your spouse, or your dependent;
- Grandparents cannot use this tax relief to help pay for their grandchild’s college tuition unless the grandparent can, on their Form 1040, claim the grandchild as a dependent;
- Room and board costs are not eligible for the exclusion; and
- The exclusion is subject to strict income limits (for 2022, the interest exclusion begins to disappear from modified adjusted gross incomes of more than $128,650 for co-filers and $85,800 for others and ends at modified AGIs of $158,650 and $100,800, respectively).
If the proceeds of all savings bonds redeemed in the year exceed the eligible education expenses paid that year, the amount of interest you can exclude is reduced proportionately.
Use IRS Schedule B and Form 8815 to report and calculate any excluded I bond interest used for education.
Buy I bonds with your tax refund
If you are eligible for a refund with your federal tax return, the IRS makes it easy for you to use some or all of that money to buy an I bond. Simply file Form 8888 with your Form 1040. You don’t have need to open an account in advance with Treasury Direct, the government clearing house for the purchase and redemption of US savings bonds. As long as you complete Form 8888, the IRS will arrange for the I Bonds to be mailed to you.
You can buy up to $5,000 in I Bonds (note that they come in $50 increments) with your tax refund. If you decide to go this route, you will receive paper I bonds in the mail issued in your name (or in your name and your spouse’s name if you filed a joint tax return). You can also use your tax refund to purchase I Bonds on behalf of someone else, such as your child or grandchild. Again, you would choose this on Form 8888.