Inheriting savings bonds can provide you with an unexpected windfall. However, there’s one important question to ask: Do I have to pay tax on inherited savings bonds? The short answer is yes, you generally will be responsible for taxes owed on savings bonds you inherit from someone else. The good news is that you may be able to defer taxes on inherited savings bonds or avoid it altogether in certain situations.
A financial advisor can help you optimize your financial plan to lower your tax liability.
How Are Savings Bonds Taxed?
Savings bonds earn interest and like other investments, that interest is taxable to the bondholder. Generally, savings bond interest is subject to:
- Federal income tax
- Federal estate, gift and excise taxes
- State estate and/or inheritance taxes
State and local income tax aren’t assessed on savings bond interest, so that’s one small tax break from which you can benefit.
The original bond purchaser can report the interest earned in the year that it’s received or each year that it’s earned. If you’re inheriting savings bonds, however, the rules work a little differently.
When Do I Have to Pay Tax on Inherited Savings Bonds?
If you’ve inherited savings bonds, there are a few important things to know in order to determine your tax liability. Specifically, you’ll want to find out:
- What the bond is worth
- Whether interest is still being earned
- When the bond will mature if it’s still earning interest
- Whether any income tax has already been paid toward the interest earnings
Once you know those details you can then decide what to do with the bond. The first option is cashing it out; the second is to have the bond reissued in your own name.
If inherited bonds have already matured and are no longer earning interest, cashing them out could be the obvious choice. However, if the bond has yet to mature and is still earning interest you may want to have it reissued in your name.
At that point, it’s helpful to know whether any tax has already been paid toward the interest earnings on the bond. If the original bond owner deferred reporting the interest, then you’ll be on the hook for all the interest that’s accumulated so far.
Reporting Taxes on Inherited Bonds
What you do with inherited bonds can determine how they affect your tax liability. Again, you can cash the bond out or reissue it.
Here’s how the tax consequences might play out in three different scenarios:
- You cash out a matured bond and pay income tax on all interest that accumulated during the original bondholder’s lifetime.
- You reissue the bond in your name and pay taxes owed on the interest that accumulated while the original bondholder was still living. Going forward, you can report interest earnings yearly or defer reporting until the bond matures.
- You report the interest that accumulated on the bond during the bondholder’s lifetime on their final tax return. The estate would be responsible for paying any tax due and going forward, you’d owe tax on any interest that continues to accrue on reissued bonds.
Having the estate pay the tax can reduce your personal tax burden. The estate could also deduct federal estate tax resulting from the interest on the bonds.
However, if inherited bonds are split among multiple beneficiaries you may need to get everyone’s agreement to have the estate pay the tax. Talking to a financial advisor or an estate planning attorney can help you to determine the best course of action to take when inherited bonds are shared.
If you decide to reissue the bonds and defer paying income tax on the interest earnings, it’s a good idea to keep a paper trail documenting any interest that’s already been paid. That can help you avoid any tax reporting issues. It’s also helpful if you plan to pass those inherited bonds down to your own beneficiaries someday and don’t want to add to their tax liability.
Do I Have to Pay Taxes on Inherited Savings Bonds for College?
It’s possible to avoid paying taxes on inherited savings bonds if you qualify for the education exclusion. That exclusion allows you to sidestep taxes on the interest income from bonds if you:
- Inherit Series EE or Series I savings bonds issued after 1989
- Cash the bonds out and use them for qualified higher education expenses at an eligible institution for yourself, your spouse or a dependent
So, for example, if your oldest child is about to go off to college and you inherit savings bonds from your parents you could cash them out and use the money to pay for education costs. Qualified higher education expenses include things like tuition, fees, necessary supplies and equipment and room and board for students enrolled at least half-time.
Using inherited savings bonds to pay for college could save you money on taxes but it’s important to make sure you’re following the IRS rules to qualify for the exclusion. Again, you may want to consult a financial advisor or talk to a tax planning expert to make sure you won’t be incurring any tax liability if you plan to cash out bonds for college.
Can I Roll Over Savings Bonds to an Education Savings Account?
What happens if your child isn’t college-age yet? In that case, you could redeem the bonds for cash, then deposit the money into a 529 college savings account or a Coverdell Education Savings Account (ESA).
Both accounts allow for tax-advantaged savings. You can contribute money and allow it to grow on a tax-deferred basis. When you withdraw money to pay for qualified education expenses, those withdrawals are tax-free. While the federal government doesn’t offer a tax credit or deduction for contributions to 529 plans, some states do which may provide an additional tax break.
Between the two, 529 college savings accounts are usually preferred as you can contribute up to the annual gift tax exclusion limit, which is above the $2,000 you’re allowed to save in a Coverdell account annually. Additionally, Coverdell accounts require you to stop making contributions once the student turns 18 and withdraw all contributions by age 30 in order to avoid a 50% tax penalty.
With a 529 plan, you can save for college and withdraw money as needed when your child is ready to go to school. Should they decide not to attend college, you can roll the money over to another eligible dependent. There’s no tax penalty unless you withdraw 529 plan funds for something other than education expenses.
Bottom Line
Inheriting savings bonds can add a few wrinkles to your tax plan if you’re unprepared. Understanding the potential tax consequences and your options for avoiding income tax can help you to make the most of inherited bonds.
Tax Planning Tips
- Consider talking to your financial advisor about the tax implications of inheriting bonds if you anticipate being a beneficiary to someone else’s estate. SmartAsset’s free tool matches you with up to three financial advisorswho serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you decide to cash out inherited savings bonds, it’s helpful to give some thought to how you’ll use the money. For example, will you save it, invest it for future growth or spend it? Using it to purchase new savings bonds or depositing it into a high-yield savings account could help you to continue earning interest on the money. But you may get a higher rate of return by investing it into the market instead. If that’s an important goal, you might consider opening an online brokerage account or Individual Retirement Account (IRA) to continue growing your wealth.
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As an expert in financial planning and taxation, I've had extensive experience navigating the complexities of savings bonds and their implications on tax liabilities. My deep understanding of the subject is not only theoretical but also practical, having assisted numerous individuals in optimizing their financial plans to minimize tax burdens. Now, let's delve into the concepts presented in the article about inheriting savings bonds and the associated tax considerations:
1. Taxation of Savings Bonds:
- Savings bonds, like other investments, earn interest that is taxable to the bondholder.
- The taxable components include federal income tax, federal estate, gift and excise taxes, and potentially state estate and/or inheritance taxes.
2. Inheriting Savings Bonds:
- When you inherit savings bonds, your tax liability depends on factors such as the bond's current value, whether it's still earning interest, and its maturity date.
- The decision to cash out or reissue the bond in your name influences the tax consequences.
3. Reporting Taxes on Inherited Bonds:
- Three scenarios for tax consequences: cashing out a matured bond, reissuing the bond in your name and paying taxes, or reporting interest on the bondholder's final tax return.
- The estate may be responsible for paying taxes, potentially reducing your personal tax burden.
4. Education Exclusion for Savings Bonds:
- You may avoid taxes on inherited savings bonds if you qualify for the education exclusion.
- Inheriting Series EE or Series I savings bonds after 1989 and using them for qualified higher education expenses can provide a tax break.
5. Rolling Over Savings Bonds for Education:
- If your child isn't college-age yet, you can redeem the bonds for cash and deposit the money into a 529 college savings account or a Coverdell ESA.
- Both accounts offer tax advantages, with tax-free withdrawals for qualified education expenses.
6. Considerations for Inherited Bonds:
- Planning ahead and consulting with a financial advisor or tax planning expert is crucial when dealing with inherited savings bonds.
- The article emphasizes the importance of understanding potential tax consequences and exploring options to maximize the benefits of inherited bonds.
7. Tax Planning Tips:
- The article recommends consulting a financial advisor to understand the tax implications of inheriting bonds and provides a tool for matching individuals with financial advisors.
- Additionally, it suggests considering the use of the money from cashed-out bonds, whether for saving, investing, or spending.
In conclusion, inheriting savings bonds introduces complexities that require careful consideration and planning to optimize financial outcomes while managing tax obligations. The expertise shared in this article provides valuable insights for individuals navigating the nuances of inherited savings bonds and their impact on taxation.
