Savings bonds are one of those inheritances that can come with hidden tax liabilities – and you won't know the extent of them until you figure out how the decedent handled the bonds during her lifetime. You'll definitely owe some tax when you redeem the bonds or when they mature, but how much depends on a few factors.
The value of your savings bonds – the principal of the investment – passes to you tax-free. Interest earned by the bonds is another matter entirely, however. Depending on where you live, the interest might incur an inheritance tax. The federal government doesn't impose such a tax, but seven states do: New Jersey, Nebraska, Maryland, Pennsylvania, Kentucky, Iowa and Indiana. In these jurisdictions, the interest – but only the interest – is subject to inheritance tax, a levy on individual bequests to certain beneficiaries.
Income in Respect of a Decedent
The interest earned by your inherited bonds is income, so somebody has to report it and pay taxes on it. The Internal Revenue Service draws a dividing line between the interest that is considered "income in respect of a decedent" and interest that is considered your income. Income in respect of a decedent is interest that the bonds earned up until the date of the original owner's death but that she did not receive yet, either because she didn't redeem the bonds or because they hadn't yet matured. Everything earned after this date is your income.
Reporting the Interest
You obviously must report your own interest income, but you may have to claim – and pay taxes on – the income in respect of a decedent as well. It depends on whether the decedent reported and paid taxes yearly on the interest over the period of time that she owned the bonds. If she did, this portion of the tax has already been taken care of and you only have to worry about the interest earned after her death. The executor of the decedent's estate should claim interest earned from the first of the year until the date of death on the decedent's final tax return and you can take over from there. Most people don't do this, however – they wait and pay taxes on the interest when they cash their bonds in. If the decedent did this, you might inherit the additional tax burden of the interest that accrued before you inherited.
Technically, income in respect of a decedent is taxable to the person or entity who receives the associated asset. If the bonds pass directly to you, this makes you responsible. If they pass through the decedent's probate estate on their way to you, however, the executor has the option of paying the tax on this portion of the interest on your behalf. You'd start with a fresh slate and only owe taxes on the interest accrued after you take ownership. At this point, you have options as well. You can defer payment of taxes on the interest until you redeem the bonds or they mature, just as the decedent had this option. Alternatively, you can calculate the interest earned and report it and pay taxes on it yearly to save yourself from a big tax hit at the end of the line. You can elect either of these options if you get stuck paying taxes on the income in respect of a decedent as well.
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