What You Must Know About Taxation of EE Series Bonds
By Jeffrey Levine, Director of Retirement Education
Follow Me on Twitter: @IRAGuru4EdSlott
Remember those savings bonds Grandma and Grandpa bought for you every year to put away for school? If you’re like most people, you – or your parents – put them in a drawer or safety deposit box until they were needed. After all, how much is there really to do with them? The answer, at least from a tax perspective, can be surprising. Although Series EE bonds (aka “college bonds”) are a very “vanilla” investment, their tax treatment is anything but. In fact, the tax treatment of these bonds is highly complex and making the right choice – yes, you actually have a choice in how you’re taxed – can lead to big tax savings if you know what you’re doing. With that in mind, here are five things you should know about the tax treatment of Series EE Bonds.
- There is No State or Local Income Tax on the Interest
As a debt obligation of the United States federal government, Series EE bond interest – like other U.S. government debt – is not taxable to state or local governments. If you live in Florida, Texas, or one of the other states with no income tax, this won’t matter much to you. However, if you live in a city and/or state with high income tax rates, such as California or New York, the exclusion of interest can cut more than 10% off of your total tax bill. That’s nothing to sneeze at.
- You Can Defer Your Interest Income
You earn interest on your recently purchased EE bonds monthly, but unlike most other interest earned outside of an IRA or other tax-deferred account, you can delay paying tax on that interest at the time you earn it. Special rules for EE bonds (and I bonds) allow you to defer the interest you earn each year until the bond matures (stops paying interest) or until you redeem them, whichever is sooner. Today’s EE bonds pay interest for 30 years, which means that, if you want, you can avoid paying tax on your EE bond gains for quite some time. That might sound great – and it often is – but there’s a big downside to this approach you should know. If you defer interest in this manner, you will generally have to pay income tax on all of the interest you’ve earned in the year your bond matures or you cash it in (whichever is sooner). Even at today’s low interest rates, that can add up to some serious income added to your tax return, which could push you into a much higher tax bracket than normal – here are the 2016 tax brackets. It could also impact other costs tied to income, such as Medicare Part B premiums.
- You Can Choose to Accrue Your Interest Income Each Year
If paying tax on all the interest you’ve ever earned on your EE bond at once doesn’t really appeal to you, you can choose to report the increase in your bond’s redemption value – aka the interest you’ve earned – each year. Choosing this option eliminates the tax-deferral benefit EE bonds offer, but can help you smooth your income and avoid a big spike down the road. Deciding which option is best requires careful analysis of your personal situation. And by the way, if you’re thinking about trying to find the optimal balance between deferring the interest on some EE bonds, while accruing the interest on others, think again! You must use the same method of accounting for all of your EE bonds.
- Lower Your Tax Bill With Higher Education
Savings bonds have long been a popular gift for children as a means of helping college savings. While these bonds may not always provide much in the way of growth – the current interest rate for Series EE bonds is a paltry 0.10% – there are some big tax advantages available if the bonds are ultimately used to fund qualified higher education expenses. To the extent such expenses – which include tuition, fees, books and even a computer used primarily by the student – do not exceed qualified Series EE bond proceeds (including principal), then any interest income as a result of the redemption can generally be excluded from your income. As such, if you’re planning to use Series EE bonds to help pay for qualified higher education expenses, you’ll typically want to defer your interest annually (as described in #2 above) rather than accrue it each year (as described in #3 above). Why pay tax on the interest if you’ll be able to exclude it all later anyway?!
- Death Provides Flexibility
If you inherit Series EE bonds from someone, there’s a good chance that they chose to defer the interest income on those bonds as opposed to reporting the income each year … most people do. Should you find yourself in this position, there’s a number of strategies you can employ to minimize the ultimate tax bill, provided you can get the decedent’s executor, personal representative or other person responsible for filing their final income tax return to “play ball.” One option is to have the bonds reissued and report the interest income earned so far on the decedent’s final income tax return. This option often makes sense if you’re in a higher tax bracket than the person from which you’re inheriting. Should you choose this option in conjunction with the executor, you’ll only be responsible for interest earned from that point on. Alternatively, the bonds can be reissued and the estate can report the income on the estate’s income tax return. This is generally not a great idea due to the compressed tax brackets estates face (here are the 2016 numbers), but if there are a lot of administration or other deductible expenses on the estate’s income tax return, it could make sense. Once again, should you choose this option in conjunction with the executor, you’ll only be responsible for interest earned from that point on. A third – and what essentially amounts to a default option – is to “hang on” to the bonds yourself and pay tax on any unreported interest earned to date – including the interest earned before the death occurred – when you ultimately redeem them or they mature, whichever is sooner.