Savings bonds are often purchased by investors as a safe, reliable investment or given as gifts. Regardless of how a savings bond is received initially, owners of savings bonds should be aware of how the bonds are taxed when cashed.
What is a Savings Bond?
A savings bond is a government bond issued by the U.S. treasury. U.S. savings bonds are often considered some of the safest investments purchasable because they are backed by the U.S. government.There are two common types of savings bonds, Series EE and Series I bonds. While they are very similar, there are some distinctions to pay attention to.
Each year, an investor may invest from a minimum of $25 in U.S. electronic Series I and Series EE savings bonds or $50 in Series I paper savings bonds up to a maximum of $10,000 in electronic savings bonds or $5,000 in paper savings bonds. While in the past bonds were sold in paper form, today a majority are sold electronically through the treasury’s website.
Savings bonds are purchased at their face value and earn interest. Series EE bonds earn a fixed rate of interest, where Series I earn a rate that is adjusted for inflation twice a year. If a Series EE bond is held for at least a 20-year term, the savings bond will be worth at least twice what it was purchased for (e.g., a $100 bond purchased today can be redeemed at maturity for $200). Bonds must be held for at least one year but can be held for up to 30 years depending on the specific terms of the savings bond.
Are Savings Bonds Subject to Tax?
Savings bonds are not subject to state and local taxes. Savings bonds used for certain qualified education expenses are eligible for tax benefits and may be used as a tax saving tool for education expenses. Taxpayers with qualified expense tax benefits may not have to pay taxes on interest if certain types of savings bonds (i.e., Series EE and Series I savings bonds) are used to pay for the qualified education expenses. Qualified education expenses include:
- Tuition;
- Fees such as student activity fees;
- Books (subject to exceptions);
- Equipment like safety glasses or goggles for the laboratory (subject to exceptions);
- Etc.
The interest paid on savings bonds when they are redeemed is subject to federal taxation. However, there are several options for when to report the interest on savings bonds.
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How Are Savings Bonds Taxed?
People who have invested in savings bonds can report the interest earned from savings bonds in two ways:
- Investors may elect to defer reporting interest income on their savings bonds until the bond is redeemed or fully matured, whichever happens first.
- Investors can report the interest and pay the tax due on it each year.
Are Savings Bonds Subject to Any Penalties for Early Termination?
If an investor redeems a savings bond prior to its maturity date, it may be subject to early redemption penalties. Investors should thoroughly review the terms of their specific bond to avoid any penalties.
Generally, savings bonds are subject to an early redemption penalty if they are redeemed before five years have passed. If the investor terminates their bond(s) before five years have passed, they forfeit the prior three months of interest. Generally, after five years, no penalty applies and the savings bond can be redeemed at any time.
Who Pays Taxes on a Gifted Savings Bond?
Often, savings bonds are received or given as a gift. They are still taxable. The interest income of the savings bond will be taxed to the bond’s owner—i.e., the recipient of the gift—when the bond matures and is redeemed for cash (or the owner will be taxed each year if they elect to report the interest income annually).
Conclusion
Savings bonds can be an excellent way to safely invest funds for the future while making a noticeable return on your investment or utilized to pay for education expenses tax-free.
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