Interest earned on a U.S. Savings Bond is taxed as ordinary income. However, the Internal Revenue Service and the U.S. Treasury offer some options that can trim savings bond tax bills, or even eliminate them altogether.
Tax Status of Savings Bonds
Interest on savings bonds is subject only to federal income tax, and can't be taxed by state and local governments. The IRS counts savings bond interest as income rather than capital gains, just as it does other interest. Interest isn't paid until you redeem a savings bond. Instead, it accrues and earns more interest. No taxes are due until either you redeem a savings bond or it matures after 30 years.
Deferring Savings Bond Interest
The person who owns a savings bond is responsible for paying income tax on the interest. When you share ownership with another person, each owner is liable for taxes in proportion to how much money each invested. When you redeem a savings bond, the Treasury Department or the financial institution where you cashed it in sends you a 1099-INT form. Include the savings bond interest on the tax return line where you report other interest and attach the 1099-INT to your return.
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Pay As You Go
Another option with savings bonds is to pay tax annually as the interest accrues. The IRS says this can be a good strategy when buying savings bonds for a child, because the interest is likely to be taxed at the child's generally low rate. When you elect to pay tax each year, you won't get a 1099-INT. You simply include the interest with other interest you report on your tax return. You have to pay tax each year on the interest earned on all savings bonds you own – you can't take the yearly option on just some of them -- and you are supposed to pay every year once you choose to start annual payments. If you want to stop paying taxes each year, you must complete IRS Form 3115 and attach it to your tax return.
The Educcation Exclusion
You may be able to exclude savings bond interest from gross income if you use the money to pay higher education costs for yourself, your spouse or a dependent. Essentially, the education exclusion means you write off the interest on your tax return. Series EE and series I savings bonds purchased after 1989 qualify for this tax break. Only bonds you purchase starting the month you are 24 years old are eligible. You must use both the principal and the bond interest to pay qualified education expenses. To claim this tax break, fill out IRS form 8815 and attach it to your tax return.