Yes, you generally pay federal income tax on the earnings of I-Bonds, but they are exempt from state and local income taxes. You have a choice regarding when to report these earnings for tax purposes, and in certain situations, you may be able to exclude the earnings from taxation altogether.
Understanding I-Bonds Taxation
I-Bonds, or Series I Savings Bonds, are a popular low-risk investment option designed to protect against inflation. While their interest rates are attractive, it's essential to understand the tax implications.
Federal Income Tax on Earnings
The interest earned on I-Bonds is subject to federal income tax. However, you benefit from a unique feature that allows you to choose when to pay these taxes.
You can opt for one of two methods:
- Annual Reporting: Report the interest earnings on your federal income tax return each year as they accrue. This might be beneficial if you anticipate being in a lower tax bracket in the current year than in future years, or if you prefer to avoid a large tax bill at redemption.
- Deferral Until Redemption: Wait to report all the accumulated interest earnings until you cash in the bond, or until it reaches its final maturity (30 years after issue). This is the most common choice, as it defers your tax liability, allowing your earnings to compound tax-free until you redeem the bond.
Key Point: Regardless of the reporting method, I-Bond earnings are exempt from state and local income taxes. This is a significant advantage, particularly for residents of high-tax states.
The Education Tax Exclusion
A major benefit of I-Bonds is the potential to entirely avoid federal income tax on the earnings if the bond proceeds are used for qualified higher education expenses. This is known as the Education Tax Exclusion.
To qualify for this exclusion, several conditions must be met:
- Bond Issuance: The I-Bond must have been issued to an individual who was at least 24 years old on the first day of the month in which the bond was purchased.
- Ownership: The bond must be owned by the taxpayer, their spouse, or held for a dependent.
- Qualified Expenses: The proceeds must be used to pay for qualified higher education expenses for the bond owner, their spouse, or a dependent claimed on their tax return.
- Examples of Qualified Expenses: Tuition and fees required for enrollment or attendance at an eligible educational institution (colleges, universities, and vocational schools that participate in federal student aid programs).
- What's NOT Included: Expenses for courses involving sports, games, hobbies, or any non-credit course unless it's part of a degree program. Room and board expenses are generally not considered qualified for this exclusion.
- Income Limitations: The full exclusion is subject to modified adjusted gross income (MAGI) limitations, which are adjusted annually by the IRS. If your income exceeds certain thresholds, the exclusion may be reduced or phased out entirely.
Tax Implications Summary
Here’s a quick overview of I-Bonds taxation:
| Aspect | Details |
|---|---|
| Federal Income Tax | Generally subject to federal income tax on earnings. |
| State/Local Tax | Exempt from state and local income taxes. |
| Timing of Tax | Choose to report earnings annually or defer until redemption/maturity. |
| Education Exclusion | Earnings may be tax-free if used for qualified higher education expenses (subject to rules and income limits). |
| Gifted Bonds | The person who receives the bond is generally responsible for taxes on earnings when redeemed. |
| Inherited Bonds | The beneficiary (heir) will owe taxes on the accumulated earnings when the bond is redeemed. |
By understanding these nuances, you can effectively plan your tax strategy around your I-Bond investments.
