If a late relative or spouse left behind savings bonds for you, they could be great assets to your financial future — if you play your cards right. But the ominous question of do I have to pay tax on inherited savings bonds? may loom in your mind.
Inheriting savings bonds is a great financial windfall, and you’ll face some taxes, but you can keep more of your inheritance by knowing the rules of the tax game. Specifically, it helps to know when you owe taxes on your inherited savings bonds and to learn ways to minimize your tax liability.
- Savings bonds include the Series EE and Series I (I bond) issued by the federal government and come with unique advantages.
- An inheritance can be helpful but often comes with a mix of state and federal taxes either on the bond’s value at redemption or interest accumulated.
- You can lower your tax bill by delaying the redemption of your bonds, reissuing them, or putting the proceeds towards select accounts and causes.
What are Savings Bonds?
A savings bond is a type of federal government bond that a person buys to save money and grow its value over time. Because the government issues them, these bonds are considered low-risk.
When a bond matures, it is redeemed for its face value (worth at maturity) and accrued interest. A bondholder can name a beneficiary to receive ownership over their savings bonds in the case of death. The beneficiary becomes the new owner of the savings bonds.
You can only inherit two types of savings bonds: Series EE and Series I.
Bought at a discount from their face value, Series EE bonds pay out their accrued interest when redeemed. They are purchased at a discount to their face value and accrue interest over time until they reach their full face value at maturity. They have a fixed interest rate that remains the same over the bond’s lifespan.
The returns on Series I bonds (aka “I bonds”) are based on a fixed interest rate and a variable rate, with all the interest paid when the bond is redeemed. The variable rate changes twice a year to match the inflation rate, as measured by the Consumer Price Index (CPI). When there is inflation, these bonds are meant to preserve the value of your cash and net you a slight return through the interest earned over the period.
I bonds became quite popular in 2021 and 2022 as they reached a peak interest rate of 9.8%. People (myself included) seeking refuge from high inflation and the stock market’s volatility bought up tons of I-bonds, lured by their high returns and lower risk.
Both types of bonds have a minimum one-year holding period, but if you hold them for less than five years, you’ll pay a penalty on the last three months’ interest. Plus, the earned interest is only subject to federal income tax, not state or local taxes. You can buy these bonds and more from the government at TreasuryDirect.gov.
How to Inherit Them
If the original bondholder named you as a beneficiary, all you need is a certified copy of their death certificate and your own ID. Then, you’ll go to Treasury Direct, contact their office, and they will transfer savings bonds to you.
Taxes and Inherited Savings Bonds
Are inherited savings bonds taxable? Yes
The best part is that beneficiaries do not have to pay state or local tax on the accumulated interest of an inherited savings bond.
But these taxes can apply on the bond’s current value or interest:
- Income tax
- Estate tax
- Excise tax
- Gift tax
- Inheritance tax
- Estate tax (this could be a graphic)
Taxes also kick in if the bond’s market value increased since it was bought. Then the beneficiary owes federal income tax on the difference between the original purchase price and the redeemed value.
For instance, if the bond was bought at $800 and was worth $1500 when redeemed, then the beneficiary will be paying taxes on the $700 increase.
Sadly, states can also tax any inherited savings bonds, but the specific details vary. Consult with a tax professional to determine how to best lower your state income taxes.
How to Shrink Your Taxes on Inherited Bonds
There are a few ways to minimize how much you’ll pay income tax, but the main choice comes down to cashing out (redemption) or reissuing the bonds in your name.
1) Delay Redemption. Postpone redeeming the bond until a year when your income is lower than usual, so you can avoid going into a higher tax bracket and reduce the number on your income tax return.
2) Pay for Education. Use the savings bond interest and principal to pay down any qualified higher education expenses. If you use the bond to pay for tuition and fees at certain schools, then the bond’s interest income is tax-free.
Most people underestimate the value of trade schools or community college courses, but the low costs of those courses would more likely match up with how much you make from only the interest.
3) Contribute to Future Education. You can cash out and rollover the proceeds into tax-advantaged, education savings accounts, such as Coverdell Education Savings Account (ESA) or 529 College Savings accounts. Your contributions will grow tax-deferred and withdrawals are tax-free if you pay for qualified education expenses, like tuition, room and board, supplies, etc.
Because these plans are offered by states, you won’t get a federal tax credit or deduction on your contributions, but some states do offer them. A 529 offers more flexibility as you can transfer the account to another child or use it on yourself and still get the tax advantage if your kid decides not to go to college.
4) Donate to Charity. Think about gifting the savings bond to a non-profit or a charity. If the organization is tax-exempt (usually a 503c), it can redeem the bond without having to pay taxes on the accumulated interest. As someone who is involved with non-profits, this is a great way to support your favorite causes and shrink your tax bill.
The Bottom Line
Savings bonds are some of the more overlooked personal finance tools. They aren’t as sexy as stocks, as their returns rarely match the S&P 500. But, they are key assets to use when you want to preserve wealth and reduce your risk as you get older. Though you’ll likely pay some tax, you can diminish that figure by putting the cash towards education or donating. You can also use the cash to save and invest in other ways, through a high savings account or in the stock market.
The biggest factor comes down to whether you want to redeem the bond or get the bond reissued in your name, to postpone its maturity. To create the best possible tax strategy, it’s a good idea to work out a plan with a financial advisor or tax professional.