If you need a safe cache for your extra cash, you could do a lot worse than a U.S. savings bond. Series EE bonds mature in 20 years and pay interest for another 10 years after that. While you can hold them for the long term, the income they generate is never treated as a long-term capital gain — the government charges you your normal marginal tax rate on savings bond interest. However, savings bonds do have some tax features that can save you money. For example, they are free from state and local taxes.
Taxes on Interest
Savings bonds do not require you to pay any income tax until you redeem the bonds. The interest that accrues each year is added to the bond value rather than distributed as a cash payment to bondholders. It is only at redemption that you actually receive your interest and incur your tax liability. The Internal Revenue Service does allow you to pay tax every year on the accrued interest you earned that year, but this is completely optional. You cannot redeem savings bonds until you've had them for one year, and you'll forfeit three months' interest if you redeem them before five years are up.
The interest you collect at bond redemption may trigger additional taxes if your individual modified adjusted gross income is over the $200,000 threshold (or $250,000 if you are a couple) effective beginning in 2013. All interest, even from tax-free municipal bonds, is counted as investment income for purposes of calculating the 3.8 percent Medicare tax. So are capital gains, dividends, rents, royalties and annuities. You owe tax on your investment income or the amount of MAGI that exceeds the threshold, whichever is less.
Savings Bonds Registered to Your Children
You may save money by paying taxes on savings bond interest each year rather than deferring it until maturity if you register the bonds in your child’s name. To qualify for certain tax treatments, the child must be under 19, or under 24 if a full-time student. If the child has less than $950 in unearned income — income from investments like savings bonds — she need not file a tax return at all. If she earns over $1,900 of unearned income, you can choose to pay the excess on your tax return or have the child pay it all by filing Internal Revenue Form 8615. Your child will have to file her own return if she earns over $9,500. Presumably, your child’s income is less than yours, so separate filing at the child’s rate may reduce or eliminate income tax on savings bonds for the filing year.
Education Tax Exclusion
If you are at least 24 years old when you buy U.S. savings bonds, you can avoid all tax at redemption by using the proceeds to pay for qualified higher education expenses such as tuition and fees. If you are the student, you should register the bonds in your name. If you intend the bonds for your child’s education, the bonds should be registered in your name and, if married, your spouse’s name. You can make the child the beneficiary of the bonds. You must spend the money on qualified education expenses in the same year that you redeem the bonds. The Treasury Direct website gives full details about this program.
- Getting the Most Out of Your Savings Bonds; Brian J. Kurtz
- Savings Bonds: When to Hold, When to Fold and Everything In-Between; Daniel J. Pederson
- Savings Bond Advisor - Fifth Edition; Tom Adams
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.