U.S. Savings Bonds were created to finance World War I. They were originally called Liberty Bonds. Because U.S. Savings Bonds are issued by the federal government, you do not have to pay state tax or local tax on the interest. Two types of savings bonds that are still available are Series EE and Series I bonds.
Series EE Bonds. Series EE bonds offer tax-free accumulation of interest until the bond is redeemed or matures. They are purchased for one-half of their face value. Most Series EE bonds have a total interest-paying life that extends beyond the original maturity date, up to 30 years from issuance.
When a Series EE bond matures, whether or not it is cashed in, the accrued interest is taxable. This is a very important point. It is important to keep careful record of your bond maturity dates - not only because they won't be earning interest anymore but also because the maturity is a taxable event. When a bond is cashed in, a 1099 is issued by the bank or financial institution to the person who is cashing in the bond. No 1099 is issued when a bond matures and is not cashed. The taxpayer is on his or her own to report the accrued income on his tax return at maturity. Making a mistake on this can result in interest and penalties owed to the IRS.
Instead of reporting accrued interest when you redeem bonds, you can choose to report the income annually. A taxpayer may elect to report all of the accrued interest on bonds through the end of the year in which the election to switch reporting methods is made. Then, in succeeding years, the individual must report the accrued interest for each year. If this election is made, it applies to all savings bonds. An individual who owns many savings bonds cannot "pick-and-choose" which bonds the election applies to.
An executor can elect to report all the accrued interest up to the date of death on the decedent's final income tax return. Then, when an heir redeems the bonds, the only interest to report will be the interest that has accrued from the date of the decedent's death.
If the election is made the taxpayer must keep careful records. Even if the election to report annually is made, the owner will still get a 1099 for the full amount of interest when the bonds are redeemed. No one wants to pay the tax twice.
Through the Education Savings Bond Program, if you cash in your bonds and use them for qualified higher education expenses, you may be able to exclude that income from taxes. Eligible bonds include Series EE Bonds issued after December 31, 1989 and all Series I Bonds. Series HH bonds are not eligible. Qualified expenses include tuition and required fees at colleges, universities and vocational schools. Room and board and books are not included. Qualified expenses are reduced by the amount of any financial aid received in the same tax year, including the amount of other education tax breaks. There are income phaseouts on the interest exclusion, based on the year in which you redeem the bonds. For 2010, the income phaseouts are $70,100 to $85,100 for single filers and $105,100 to $135,100 for married taxpayers filing jointly.
Series I Bonds. These bonds are sold at face value and grow with inflation-indexed earnings for up to 30 years. They are purchased at face value and you can buy up to $5,000 in I bonds in any calendar year. All Series I bonds have a final maturity at 30 years from the date of issue. The current interest rate for I Bonds purchased May 1, 2010 to October 31, 2010 is 1.74%. I Savings Bonds must be at least 1 year old before they are eligible for cash-in. There is a 3-month penalty for cashing in an I Bond before it is five years old, unless a Federal Disaster is declared.
Series HH Bonds. Beginning September 1, 2004, owners can no longer reinvest matured HH bonds or exchange EE bonds for HH bonds. Existing HH Bonds will be allowed to mature.
Series HH bonds were purchased at their face amount and pay interest semi-annually. They are redeemable at face value, mature in 20 years and were issued from January 1980 to August 2004. When EE bonds were used to acquire HH bonds, the amount of accrued interest in the EE Bonds is "rolled over" into the HH bonds and is not taxable income until the HH bond is redeemed or matures. The amount of accrued E or EE interest rolled over into the H is printed on its face.