How to Lower Your Taxes on Savings Bond Interest

Posted by Madison on January 16, 2012

Reporting savings bonds on your tax return usually follows a standard course of action, you get a savings bond, hold it for multiple years, then redeem it and report it on your taxes in the year of redemption.

But did you know there’s another way to report the savings bonds interest, which could potentially save money on taxes? The option to report savings bonds interest annually could be especially appealing for kids who receive savings bonds as gifts.

Options for Reporting Savings Bond Interest

There are 2 methods for reporting the interest on savings bonds, including series E, EE, and I bonds:

  • Cash reporting: Deferring the interest income until redemption or maturity, usually the default method people use.
  • Accrual reporting: Report savings bond interest annually.

Tax Savings Opportunities with Annual Reporting

If you use the method to report the savings bond interest annually and you pay the tax each year for someone in a very low tax bracket (which usually includes young children), the tax due is often zero or very small.

Kids won’t owe tax if their income is below the amount that requires a child to file a tax return. However, if you’re going to be reporting a substantial amount of interest each year, you still have to watch out for the kiddie tax.

In the long run, if you manage it correctly, the taxes paid on the interest should be lower than what you’d pay if you wait to redeem the bonds when they are older, and most likely, in a higher tax bracket. After all, there most likely won’t be many more opportunities in life to take advantage of 0% tax rates.

Things You Should Know

Ownership requirements. Bonds must be issued in the child’s name to use this strategy for the kids. Parents can be listed as a beneficiary, but not co-owners.

It applies to all bonds. If you elect the annual reporting, you have to report interest annually for all savings bonds your child owns, including both electronic and paper bonds. You cannot select different bonds to use different methods.

Your election continues into the future. If you start reporting the interest annually, you have to keep reporting it annually going forward (including bonds you get at a later date).

You need good recordkeeping. In the year you redeem the savings bonds, you’ll need to remember that you already paid the interest and only pay tax on the interest for the final year. In addition, since you won’t get an annual 1099, you’ll have to calculate and report your own interest on the bonds each year.

No impact to state tax. The election you make won’t impact your state taxes; savings bonds are exempt from state tax.

Education exclusion. Some people may be hoping to wait to cash in the savings bonds to line up the redemption with college expenses to take advantage of the Savings Bond Education Tax Exclusion, but this exclusion can’t be used for bonds issued in a child’s name. It’s something to be aware of and determine if your bonds are issued that way.

How to Report Interest Annually

If you want to switch from deferred reporting to annual reporting, you can do so by reporting all of the interest so far on the bonds (through the end of the tax year). You don’t need to go back and amend previous returns.

  1. Use the government savings bond calculator to calculate interest on all the bonds through December.
  2. File your return, (or a child tax return, if the bonds belong to your kids) to report the interest.
  3. Report the total interest accrued so far and note on the tax return that you’re switching to the method to report savings bonds interest annually.
  4. In future years you can use the YTD function on the calculator to determine the interest amount. You’ll need to keep track of the amounts, but you don’t need to file a tax return for your child unless he is required to file a child tax return.

If you ever need to switch back in the future, declare your change using form 3115 (but switching back is much more complicated than the original switch).

Action Plan

I’m planning to switch our 2 year old to the annual method this year since she doesn’t have much other interest income (a casualty of being the third child!) and she’ll pay zero tax on the bond interest for the foreseeable future. Since it will be an easy, straightforward return, I’m going to use TurboTax to file a free return.

Which method do you use to report your savings bond interest for your kids?

Get your biggest tax refund, guaranteed. Plus FREE Expert Tax Advice. File your Federal tax return for FREE today with TurboTax!

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Comments to How to Lower Your Taxes on Savings Bond Interest

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