Do Inherited Savings Bonds Get a Stepped-Up Basis?
Understand how inherited savings bonds are taxed, including cost basis rules, interest reporting, and key exceptions that may affect your tax liability.
Savings bonds are a common way to pass down wealth, but inheriting them comes with tax implications that can be confusing. Unlike stocks or real estate, which typically receive a stepped-up basis when inherited, savings bonds follow different rules that affect how much tax is owed. Understanding these distinctions helps beneficiaries decide whether to cash in the bonds immediately or defer taxation.
Cost Basis Rules for Inherited Bonds
When someone inherits savings bonds, the cost basis is the original purchase price plus any accrued interest that has not yet been taxed. Unlike stocks or real estate, which reset to their fair market value at the time of the original owner’s death, savings bonds retain their original cost basis. This means any interest earned before inheritance remains taxable when the bonds are redeemed.
For example, if a Series EE bond was purchased for $500 and had accrued $300 in interest by the time the owner passed away, the heir inherits the bond with a cost basis of $500, but the $300 in interest is still taxable. The new owner does not get to reset the basis to the bond’s total value at the time of inheritance.
In some cases, the estate may report the accrued interest on its final tax return, relieving the beneficiary of that tax burden. If this election is not made, the heir is responsible for paying taxes on all interest earned when they cash in the bond. This can lead to a significant tax bill, especially if the bond has been held for decades and accumulated substantial interest.
Tax Considerations for Inherited Savings Bonds
The tax treatment of inherited savings bonds depends on how interest income is handled. Since these bonds continue accruing interest until they are redeemed or reach final maturity, beneficiaries must decide when to recognize this income. Deferring redemption allows interest to compound tax-deferred, but it also means a larger taxable event later. If the bonds are cashed in immediately, all untaxed interest becomes reportable income in that tax year.
For heirs in higher tax brackets, this can create a significant tax burden, as the interest is taxed at ordinary income rates rather than the lower capital gains rates that apply to inherited stocks or real estate. A large redemption could push a taxpayer into a higher bracket. Additionally, state income taxes may further increase the total liability. Some states, such as Florida and Texas, do not impose an income tax, while others, like California and New York, have high marginal rates exceeding 10%.
One way to reduce the tax impact is to cash in the bonds gradually over multiple tax years, spreading out the income to avoid a sudden spike in taxable earnings. This approach can be useful for retirees or individuals with fluctuating income, as it allows them to manage their tax bracket more effectively. Another option is using the interest to pay for qualified higher education expenses, which may allow for tax-free treatment under the Education Savings Bond Program. However, eligibility criteria apply, including income limits and the requirement that the bonds be registered in the name of the taxpayer, spouse, or dependent.
Exceptions to Basis Adjustments
Certain circumstances can alter how savings bonds are taxed. One exception arises when bonds are co-owned. If a savings bond is jointly held and one owner passes away, the surviving co-owner automatically becomes the sole owner without triggering an immediate tax event. The deceased’s portion of the bond is not stepped up in basis, but the survivor continues to defer taxes until redemption.
Another exception occurs when savings bonds are transferred to a trust. If a revocable living trust owns the bonds, they remain part of the trust’s assets upon the grantor’s death. The successor trustee then decides whether to redeem, distribute, or maintain the bonds. Depending on how the trust is structured, income tax liability may fall on the trust itself or pass through to beneficiaries. Trust tax rates are typically higher than individual rates, making tax-efficient distribution strategies essential.
In some cases, bonds may be donated to a qualifying charitable organization, eliminating any income tax liability for the donor or their heirs. Since charities are tax-exempt, they can redeem the bonds without incurring tax on the accrued interest. This strategy can be useful for individuals with large estates looking to reduce their overall taxable estate while supporting a philanthropic cause. Proper documentation and compliance with IRS regulations are necessary to ensure the donation is recognized for tax purposes.
Interest Reporting Requirements
Financial institutions play a central role in ensuring compliance with tax regulations when a beneficiary inherits savings bonds. The U.S. Department of the Treasury requires that interest earned from these bonds be reported on IRS Form 1099-INT in the year of redemption. This form is issued to the bondholder and the IRS, detailing the total taxable interest accrued. If a bond reaches final maturity, the interest is reported even if the bond is not redeemed, as tax deferral ends at that point.
Beneficiaries who receive savings bonds through an estate must verify whether any interest was previously reported by the decedent. If the estate executor elected to include accrued interest on the final income tax return of the deceased, this amount should not be reported again by the heir. If no such election was made, the beneficiary assumes full responsibility for recognizing the deferred interest upon redemption. Proper record-keeping is necessary to avoid discrepancies that could trigger IRS scrutiny, as unreported interest income may result in penalties or additional tax assessments.