Understanding the Tax Implications of Interest Earnings on Savings Bonds

How is Interest on Savings Bonds Taxed?

Savings bonds are a popular investment choice for individuals looking to save money for the future while earning interest. These bonds are issued by the U.S. government and come in two main types: Series EE and Series I. One of the key questions many investors have is how the interest earned on these bonds is taxed. In this article, we will explore the tax implications of interest on savings bonds.

Understanding the Taxation of Savings Bond Interest

Interest on savings bonds is considered taxable income for federal income tax purposes. However, the good news is that the interest is exempt from state and local taxes. This makes savings bonds an attractive investment option for those looking to save on taxes while earning interest.

Federal Taxation of Savings Bond Interest

When it comes to federal taxation, the interest on savings bonds is taxed at the time the bond is cashed in or when it reaches maturity. The interest is reported on the bondholder’s annual tax return using Form 1099-INT. It’s important to note that the interest is not taxed when the bond is first purchased, but rather when it is redeemed or matures.

Reporting Interest on Savings Bonds

To report the interest on savings bonds, bondholders must use Form 1040, Schedule B. The interest earned on Series EE and Series I bonds is reported as “Original Issue Discount” on Schedule B. This amount is then included in the bondholder’s taxable income on Form 1040.

Special Tax Considerations for Series I Savings Bonds

Series I savings bonds have an additional feature that can affect their taxation. These bonds are indexed for inflation, which means that the interest rate can adjust periodically based on the Consumer Price Index (CPI). The adjusted interest rate is taxed when the bond is redeemed or matured, and the inflation adjustment is considered taxable income.

Exemptions and Credits

While the interest on savings bonds is generally taxable, there are some exceptions and credits that may apply. For example, interest on Series EE and Series I bonds issued after 1989 may be excluded from income if used to pay for qualified higher education expenses. Additionally, some tax credits, such as the American Opportunity Tax Credit, may be available to offset the tax burden on savings bond interest.

Conclusion

In conclusion, the interest on savings bonds is taxable for federal income tax purposes but exempt from state and local taxes. It’s important for investors to understand the tax implications of these bonds when planning their investment strategy. By knowing how interest on savings bonds is taxed, investors can make informed decisions and potentially save on taxes while growing their savings.