I was born during the late 80s. During that time it was popular for people to buy savings bonds for children. It was an investment into the child's future. I would go as far as to say it was a popular gift from grandparents, great aunts, and great uncles. Well, now my fellow Millennials are having to deal with this savings tool from the past. Why? Because they are maturing.
What Grandma and Grandpa didn't tell you is that you will have to pay taxes on some of the bond when it matures. The interest. Today I'm going to walk you through a tax strategy that can help you avoid paying that tax. So grab your pen and paper as I break down how to avoid paying taxes on savings bonds.
What is a U.S. Savings Bond?
Before I get too deep into the process it's important that you understand what a savings bond is. A U.S. savings bond is a loan to the government. When you buy a bond you are giving your money to the United States. They then guarantee that they will pay it back with interest at a predetermined date.
Note: There are many types of bonds so I want to make a distinction that we are talking only talking about U.S. savings bonds today.
These bonds were born in 1935 during President Franklin D. Roosevelt's time in office. He signed a law allowing the Treasury Department to sell the first bonds at $25. Since that time the U.S. has issued many more bonds. Until 2012 taxpayers could purchase them at banks. Now you can only buy U.S. savings bonds from the government online. You can even purchase them with your tax refund.
There are two different types of U.S. savings bonds:
Series I Bonds
Series I bonds pay a fixed interest rate based on inflation. This protects you as an investor from inflation and is very low risk. You earn a fixed rate of interest and a rate that changes. The inflation rate is set in 6-month intervals.
You can have a bond for 30 years but you can cash it in after 12 months. There are consequences to cashing it in early. If you cash it in less than 5 years you lose the last 3 months of interest.
This means if Joyce purchases a Series I U.S. savings bond and holds it for 48 months she will only receive 45 months of interest.
You do have to pay Federal income taxes on Series I savings bond interest. But you do not have to pay taxes at the state and local levels. You can report the interest each year you earn it or when you cash the bond. You will report it on Schedule B of your 1040. You can avoid these taxes by using the money for qualified higher education expenses.
Series EE Bonds
Series EE bonds earn interest regularly for 30 years. They do not protect you from inflation. However, they have a guarantee that your investment will double after 20 years. Even if the government has to add the difference at year 20.
Let's say Kim's grandparents purchased a $10,000 series EE savings bond for her in 1992. In 2012 the bond would have been worth $20,000.
The interest on series EE bonds compounds semiannually. This means that every 6 months the government applies the interest rate to a new principle amount. This allows it to grow faster because the principle is also growing.
New series EE bonds, since May 2005, earn a fixed rate of interest for the first 20 years. The government may adjust the rate after that time. There are different rules for how the interest is compounded for earlier years. The time frames are:
Before May 1995
May 1995 - April 1997
May 1997 - April 2005
May 2005 - present
You do have to pay Federal taxes on the interest your series EE savings bond earns. You do not have to pay taxes at the state and local levels. The reporting is the same as series I bonds. You can also avoid paying taxes on the interest if you use the funds for qualified higher education expenses.
How to avoid paying taxes on U.S. savings bonds
The part we have all been waiting for...who can cash in their bonds tax-free? Like most IRS topics, it depends. You may qualify if you meet certain criteria. Part of that criteria includes an income threshold.
Your filing status is not married filing separately.
Your 2022 Modified Adjust Gross Income (MAGI) is less than $158,650 if married filing jointly and $100,800 if head of household status.
The owner of the bond is at least 24 years old before the bond's issue date.
The government issued the bond after 1989.
You pay qualified education expenses for yourself, your spouse, or a dependent.
If your dependent is not college-age yet you can roll the money into a college savings account. These qualified tuition programs are better known as 529 accounts. Coverdell education savings accounts also qualify. This strategy will allow the money to grow even more to help pay for your dependent's higher education expenses. The principle will be tax-free if your dependent uses the money for the intended purposes. Then only the interest will be taxable.
If you do have current higher education expenses to pay these are the qualified expenses.
Tuition and fees are required for enrollment.
Contributions to a qualified tuition program (QTP).
Contributions to a qualified Coverdell education savings account (ESA).
You will have to reduce those expenses by any of the following tax-free benefits if you have them.
The tax-free part of scholarships and fellowship grants.
Expenses used to figure tax-free distribution from a Coverdell ESA
Expenses used to figure tax-free distribution from a QTP
Any tax-free payments (excluding gifts or inheritance) such as Veteran's educational benefits. Qualified tuition reductions and employer-provided educational assistance also count.
Any expenses used to figure out the American opportunity and Lifetime learning credits.
Unfortunately, if your income is above the thresholds mentioned above will not qualify for the U.S. savings bond exclusion.
Form 8815
If you have met all of the criteria so far, congratulations! You can exclude the interest from your series EE and series I U.S. savings bonds on Form 8815 of the 1040. Form 8815 helps calculate the amount of interest that you can exclude from your tax return. If all the interest was not used for a qualified higher education expense you will stay pay taxes on that amount.
Let's say that Kelli and Jarrod are a married couple filing jointly for 2022. In December of 2022, they cashed a qualified series EE U.S. savings bond from Kelli's grandparents. They received $12,000. $9,000 of that was principal and $3,000 was interest. In 2022 they paid $10,700 of their son's college tuition. They are not claiming any education credits and their son did not receive any education assistance. Their MAGI was $120,000. This is below the phase-out level so they can exclude the full eligible amount.
Kelli and Jarrod will be able to exclude $1,700 in interest from their income. They will still have to pay taxes on the remaining $2,300 that was not used for higher education expenses.
If in your planning you find that you were not able to exclude the interest, and now have a tax bill you can't pay don't fret. If you otherwise tax compliant and can pay it off within 36-72 months you may qualify for a Guaranteed Payment Plan. Check out my e-book Guaranteed Payment Plan to have your payment arrangement set up as soon as possible.
Summary
Savings bonds are a very low-risk savings tool. Qualifying taxpayers that have U.S. savings bonds maturing can avoid paying tax on the interest. The taxpayer will have to pay taxes on the interest if it is not used to pay a qualified higher education expense. Rolling the interest into a Qualified Tuition Program (529) or Coverdell education savings account is a good tax strategy for parents. It can help them lower their tax bill and save for their children's education at the same time.
Timalyn S. Bowens EA is America's Favorite EA and Tax Expert who will work hard to find a customized legal solution for you! As an Enrolled Agent licensed through the Internal Revenue Service Timalyn is able to fight the IRS for taxpayers in all 50 states. As the host of Tax Relief with Timalyn Bowens and a YouTube content creator she empowers taxpayers to make educated decisions about their tax situation.
When you are facing questions regarding your personal or business taxes, working with a professional makes all the difference. At Bowens Tax Solutions, we serve our Louisville-area neighbors by providing the tax services and knowledge needed to succeed. We are here to assist you with your tax issues and preventative care. Visit our website at www.bowenstaxsolutions.com for more information..