Savings Bonds Interest: Pay Tax Now or Later?

Savings bonds give you the option to pay taxes on the interest each year or when you cash the bond. So which should you choose?

Savings Bonds Interest Tax Choice

Savings bonds are a special type of bond. Generally with bond investing, you always have to pay interest as you go. If the bond pays interest, you pay tax on that interest in the year you receive it. If you bought a zero-coupon bond that doesn’t pay interest but gave you a discount when you bought it, you pay tax based on an assumed rate of interest calculated according to the discount.

Savings bonds give you a choice of when to pay taxes. You can either pay tax like a regular bond, or you can wait until you cash the bond and pay tax on all of the interest at once.

Do you want to do less math and less paperwork?

When you buy savings bonds from TreasuryDirect, you only get a 1099 when you cash the bond. If you don’t pay tax until you cash it, you can just plug the 1099 into your tax return.

If you want to pay tax as you go, you TreasuryDirect won’t help you. You have to look up how much interest you earned each year and report it on your tax return. You’ll still get a 1099 for the full amount of interest when you cash the bond and will have to note on your tax return that you don’t owe tax on all that interest because you already paid most of it.

Do you want more control over your income?

Paying all the tax at once can lead to an unexpected spike in your income. That’s because all of the interest is included in your Adjusted Gross Income. For example, say you bought the $10,000 annual limit in EE bonds and cashed them when they doubled in value at the 20-year mark. That’s an extra $10,000 in taxable income.

This could potentially:

  • Cause some of the interest to be taxed in a higher tax bracket if splitting it up in previous years would have left you in a lower tax bracket.
  • Push you over cliffs like the 400% AGI limitation for an Obamacare subsidy, the cutoff for a 20% QBI deduction, or the income limit for a deductible or Roth IRA.
  • Render you ineligible for other income-based benefits.

Do you want to take full advantage of compounding interest?

Paying tax when the bond matures means you have tax-free compounding. While you pay as-you-go taxes from your checking account instead of withdrawing from the bond, that’s still cash flow you could have invested.

Are you in a lower or higher tax bracket now?

If you expect to move to a higher or lower tax bracket in the future, it can make sense to choose to pay taxes when you expect your tax rate to be lowest.

If you think you’re in a lower tax bracket now, you may want to pay as you go. If you think you’re in a higher tax bracket now, you may want to wait until you cash your bonds.

When do your savings bonds mature?

Savings bonds mature after 30 years if you haven’t cashed them already. While you can still hold them after that, they stop earning interest and you have to pay tax on the interest as of the maturity date.

If your bonds will mature after you plan to retire, you might feel comfortable assuming your income will be lower. If you expect to still be in your peak earning years, you might want to pay tax each year to avoid the large income.

What are the taxes on Series I Bonds?

Series I savings bonds are getting a lot of buzz lately. From November 2021 through April 2022, they paid a 7.12% interest rate. Starting in May 2022, they’ll pay 9.62%.

I bonds follow the usual rules for savings bonds described above. If you’re new to savings bonds, there are a few things you need to know about buying them.

  • I bond rates adjust with inflation every six months. If inflation is back down to 0% next November, your I bonds will pay 0% for the next six months.
  • You can’t cash savings bonds for any reason until you’ve held them for 12 months. Don’t use emergency fund money or home down payment money you may need to access before then.
  • If you cash your savings bonds before holding them for five years, you give up the last three months’ worth of interest.

When you cash in your I bonds or opt to pay your taxes annually, you pay income tax on all interest you earned. You don’t get any kind of deduction or offset for inflation.

If inflation is 10% and you’re in the 24% tax bracket, your interest after taxes is effectively 7.6%. That means you’re still trailing inflation after taxes. The 7.6% return might still be a good option for you from an investment standpoint, but it’s important to know how I bond taxes work when you decide what to do. With taxes included, I bonds don’t match inflation.

Conclusion

There’s no right or wrong answer for when to pay taxes on savings bond interest. You can’t even know you’re making the best choice without a crystal ball to know your exact income and tax rates for future years, so just make a decision and stick with it.