How to Avoid Paying Taxes on Savings Bonds

U.S. savings bonds, specifically Series EE and Series I bonds, are a secure investment option. While interest earned on these bonds is generally subject to federal income tax, strategies and exemptions can significantly reduce or eliminate this obligation. This article explores savings bond taxation and outlines approaches to minimize the associated tax burden.

Basics of Savings Bond Taxation

Interest accrued on U.S. Treasury savings bonds is subject to federal income tax. These bonds are exempt from state and local income taxes, offering a tax benefit compared to many other investments. The interest earned represents the difference between the bond’s purchase price and its redemption value.

Bondholders have two primary methods for reporting this interest for federal tax purposes. The first is the accrual method, where taxpayers elect to report the interest as it accumulates each year. This option might be appealing to individuals in lower tax brackets, as it allows them to recognize smaller amounts of income annually rather than a large sum later. If this election is made, it applies to all savings bonds owned by the taxpayer and any acquired in the future.

The more common approach is the cash method, which permits bondholders to defer reporting the interest until the bond matures, is redeemed, or is otherwise disposed of. This deferral allows interest to accumulate tax-free until a future date, potentially aligning income recognition with a period of lower overall income. When the interest is finally reported, it is included on Schedule B (Interest and Ordinary Dividends) of Form 1040.

Tax Exclusion for Qualified Education Expenses

A specific federal tax exclusion allows bondholders to avoid paying tax on interest earned from Series EE and Series I savings bonds if the proceeds are used for qualified higher education expenses. This exclusion applies to bonds issued after 1989. To qualify, the bond must be registered in the name of the taxpayer, or jointly with a spouse; the student for whom the expenses are paid cannot be the sole owner of the bond. The bond owner must also have been at least 24 years old on the bond’s issue date.

Qualified higher education expenses include tuition and fees required for enrollment or attendance at an eligible educational institution for the taxpayer, their spouse, or a dependent claimed on their tax return. Expenses such as room, board, and books do not qualify for this exclusion. Any nontaxable educational benefits, such as scholarships or employer-provided assistance, reduce the amount of qualified expenses.

The ability to claim this exclusion is subject to Modified Adjusted Gross Income (MAGI) limitations, which can phase out or eliminate the benefit as income increases. For example, in 2025, the exclusion begins to phase out for single filers with MAGI exceeding $99,500 and is completely eliminated at $114,500. For those married filing jointly, the phase-out starts at $149,250 and is fully eliminated at $179,250. Taxpayers use Form 8815 to calculate and claim this exclusion.

Additional Strategies for Tax Reduction

Beyond the education exclusion, taxpayers can employ other strategies to minimize the tax burden on savings bond interest. One approach involves strategically using the deferral option available for reporting interest income. Since interest can be deferred until redemption or maturity, bondholders can plan to redeem bonds in years when their overall income is lower. This might occur during retirement, periods of unemployment, or other times when an individual’s marginal tax rate is reduced. By timing the income recognition, the interest is taxed at a potentially lower rate.

Gifting savings bonds to individuals in a lower tax bracket presents another opportunity for tax reduction. When a bond is gifted, the interest income is taxed to the recipient upon redemption. If the recipient, such as a child or grandchild, is in a significantly lower income tax bracket, the overall family tax liability on the bond’s interest can be reduced. While “kiddie tax” rules may apply to children’s unearned income, gifting bonds can still be beneficial, particularly if the child’s income is below these thresholds or if bonds are held until the child is older.

Donating appreciated savings bonds directly to a qualified charity can also provide tax advantages. If savings bonds are bequeathed to a charity through a will, the charity, being tax-exempt, does not pay tax on the accrued interest when it redeems the bond. This method can relieve the estate of potential income and estate tax liabilities on the bond’s appreciation. While gifting savings bonds directly to a charity during one’s lifetime results in the donor recognizing the accrued interest as taxable income, the donor may also claim a charitable deduction for the bond’s fair market value, potentially offsetting the recognized income.