How are I bonds taxed?

How are I bonds taxed?

Key points

  • Interest earned on I bonds is exempt from state and local tax but subject to federal tax.
  • The interest is taxed in the year the bond is redeemed or reaches maturity, whichever comes first.
  • Investors can defer paying taxes on the interest until the bond is redeemed or matures, or they can pay taxes annually on the interest earned.

I bonds can provide a secure means of generating returns that are moderately insulated from inflation. This investment type is particularly prudent during periods of rapid inflation, which has been the case since 2021. Inflation rose to a 40-year high of 9.1% in June 2022 and was hovering around 5% as of March 2023. With these rates, I bonds are investments to keep your eye on.

I bonds are backed by the U.S. government and pay an interest rate that consists of two parts: a fixed rate and a rate that changes with inflation, as measured by the consumer price index. Adjustments to the variable rate are made twice a year.

Like with any investment, it’s important to understand the tax implications to determine if I bonds are right for your portfolio and long-term goals.

Do I have to pay taxes on I bonds?

Yes, I bonds are subject to taxation. But they provide certain tax benefits that distinguish them from other investments and can result in lower tax payments.

The original amount you invested in the bond isn’t taxed, but the interest earned is. 

The good news is “taxes are only owed to the federal government and not to any state governments, being that states do not tax interest on federal obligations,” says E. Martin Davidoff, partner in charge of Prager Metis’ National Tax Controversy Practice. “You can choose to report the interest on the bond value each year, or you can pay when the bond matures. Which one you choose depends on your personal tax situation.” 

The only time I bonds may escape federal taxes is if the money is used to pay for higher education. Among the many criteria you must meet to take the tax exclusion, your income must be under certain limits and you must apply the money to a qualified institution the same year you redeem the bond. To take the tax exclusion, you must complete IRS Form 8815.

You can learn more about what you need to qualify on the Treasury Department’s website.

Does everyone have to pay taxes on I bonds?

If your name appears as the owner of record for the I bond, you are responsible for the taxes. If you co-own the bond, you and the other person must each report the interest in proportion to how much you each paid for the bond.

If you surrender the bond and it is subsequently reissued, you are accountable for paying taxes on the interest accrued up until the point of reissuance. Likewise, if you become the new holder of a reissued bond, you are required to pay taxes on the interest earned from the moment the bond is reissued.

A 1099-INT issued when you cash the I bond will show all interest earned from the date of issue, including interest earned before it was reissued. IRS Publication 550 has instructions for paying tax only on the interest earned after the bond was reissued.

You might get away with not paying any tax on the I bond if the proceeds of the bond are used to pay for higher education. But make sure to check the fine print on IRS Form 8815 to see if you meet the criteria to take advantage of this benefit.

When do I need to report interest on bonds?

You choose when you report the interest on I bonds, which is another advantage.

Most people report the interest on their federal income tax return the year they give up ownership of the bond and receive what the bond is worth, including the interest. But others may find it advantageous to report the interest each year.

How do you report interest on your tax return?

The interest on your I bond falls on the same line as other interest income whether you choose to report it every year or all at once at the end of your ownership.

Interest the bond earns is reported on a 1099-INT after the bond is cashed or reissued. The 1099-INT will show all the interest the bond has earned over the years. You can find instructions in IRS Publication 550 on how to tell the IRS that you already reported some or all of that interest in earlier years.

What if I don’t receive a 1099-INT?

Even if you don’t receive a 1099-INT, you must report the amount as part of your interest income on your federal tax return. You don’t need to attach it to your return.

If you’re not sure how much to report, you can try to contact the payer, which is the Treasury, request an IRS transcript of your tax information or check your account online. If worse comes to worst, you can contact the IRS for help, but wait times are notoriously long.

Can I use my tax refund to buy I bonds?

One of the drawbacks of investing in I bonds is that the cap on how much you can buy is relatively low at $10,000 per person in a calendar year. But you can sneak in another $5,000 if you use your federal income tax refund to buy paper I bonds.

What is the qualified education expense exception?

If you spend the proceeds of your I bond on higher education, you may be able to skip paying taxes on the bond. There are many criteria you must meet to take this exemption, which include: 

  • The bond owner must have been 24 years old or older when the bond was issued.
  • The modified adjusted gross income must not exceed the cutoff amount specified by the IRS for the tax year when the exclusion is claimed. For 2022, the income cutoff was $100,800 for single filers and $158,650 for those married filing jointly.
  • The savings bond must be redeemed in the same tax year the exclusion is claimed.
  • The savings bond must be used to pay for qualified higher education expenses for the bond recipient, their spouse or their dependent.
  • The expenses must be for an eligible institution, and you must keep necessary records — such as bills or receipts showing you paid for higher education expenses — per IRS guidelines. 
  • The IRS tax return must be filed under any status except married filing separately.

You can learn more about what you need to qualify on the Treasury Department’s website. And in order to take the exemption, you’ll need to complete IRS Form 8815.

Strategies to avoid or minimize taxes on I bonds

Davidoff says there are three ways I bond taxes can be avoided or minimized:

  1. I bonds are used for college expenses. 
  2. I bonds are owned by people with low incomes who report the interest annually.
  3. The owner defers — and therefore avoids — interest until maturity.

Investors should carefully consider their current and future tax brackets when deciding whether to defer taxes. 

Deferral can impact the present value of taxes by not increasing your tax bill, Davidoff says. But it may also benefit someone who expects to have a lower tax rate in the future if their income decreases and cashing in the bond becomes more important, he adds. 

“However, if income is expected to increase in future years when the bonds are cashed in — such as for a home purchase — it may be advantageous to cash in the bonds during years with lower tax rates,” Davidoff says. “It’s truly a careful balancing act”.

Tax advantages of Series I bonds vs EE vs TIPS

Taxwise, there’s little difference between I bonds and EE bonds, so deciding which to buy depends on your investment goals. Like I bond investors, EE bond investors have the option to report the interest earned each year or once in the year the holder relinquishes ownership or the bond matures. Both bonds are subject only to federal income taxes, not state and local taxes, but may qualify for an exclusion if the money is used toward college costs.

EE bonds pay a fixed interest rate but are guaranteed to double in value after 20 years regardless of the rate, while the I bond interest rate is adjusted twice per year based on the consumer price index. An I bond’s value isn’t guaranteed to grow a certain amount. To learn more about EE bonds, you can check out the Treasury Department’s website.

Treasury inflation-protected securities, or TIPS, on the other hand, have a major tax disadvantage that makes them better held in tax-advantaged accounts.

Both TIPS and I bonds are adjusted for consumer inflation, but the difference is that the adjustment is made twice a year to the principal on TIPS instead of the interest rate.

Because TIPS pay out interest twice per year, these investments are good for people seeking regular income but bad for tax purposes. You have to pay tax on each payout as well as the inflation adjustment to the bond’s principal.

That makes them a far better choice for tax-sheltered accounts like individual retirement accounts and 401(k)s than your taxable account, says Christine Benz, director of personal finance at Morningstar.

Frequently asked questions (FAQs)

No, the interest income earned from I bonds is not considered a capital gain and is therefore taxed differently. Instead, it is taxed as regular income at the federal level and exempt from state and local taxes. The tax is due in the year when the bonds are redeemed or reach maturity, whichever comes first, and investors have the option to defer the payment of taxes until that time.

When someone who owns I bonds dies, the executor of their estate has the option to include all the interest earned up until the date of death on the deceased person’s final tax return. In that case, the beneficiary of the bonds will owe taxes only on the interest earned after the owner’s death. But if the executor doesn’t include the interest earned up until the date of death on the final tax return, the beneficiary will have to pay taxes on all the interest earned when the bond is redeemed or matures, whichever happens first. 

Yes, you are required to pay federal income taxes on the interest earned by inherited series I savings bonds. The interest is taxed in the year it is earned and must be reported on the beneficiary’s tax return. The amount of tax owed depends on the beneficiary’s tax bracket and the amount of interest earned. The beneficiary may also decide to defer taxes if they wait to redeem the bond.

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