Taxes on I Bonds Get Complicated If You Go Against the Default

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Taxes on I Bonds Get Complicated If You Go Against the Default

Taxes on I Bonds are dead simple if you don’t do anything extra. You make it a lot more complicated when you go against the default.

Table of ContentsThe Default – During Your Lifetime The Default – After You Die Optional – Pay Up In the Year of Death Optional – Report Interest Every Year No Annual 1099 No Periodic Statements Value on December 31 or January 1?Unrealized Early Withdrawal Penalty Bond-by-Bond Tracking Required Risk of Paying Tax Twice Savings Bond CalculatorThe Default – During Your Lifetime

By default, you don’t pay any taxes while you’re holding I Bonds during your lifetime. You pay federal income tax on the interest accumulated over the years only when you cash out or when the bonds mature after 30 years. It’ll be taxed as ordinary income, not long-term capital gains. The interest is exempt from state and local taxes. There’s no RMD in I Bonds.

If you do a partial cashout from a purchase, TreasuryDirect will split the cashed-out amount proportionately into principal and interest. Suppose you originally bought $10,000 and the $10,000 grew to $15,000 with interest. When you cash out $3,000 from this purchase, which is 20% of the total value, TreasuryDirect will split it into $2,000 principal and $1,000 interest. You’ll pay tax on $1,000.

TreasuryDirect will track and calculate the interest for you. They’ll generate a 1099-INT form for the year when you cash out any I Bonds or when any I Bonds mature. You log in to your account and download the 1099 form.

The Default – After You Die

The second owner or beneficiary on your I Bonds inherits those bonds after you die. Be sure to keep your second owner or beneficiary designations up to date. See How to Add a Joint Owner or Change Beneficiary on I Bonds.

By default, your second owner or beneficiary doesn’t pay any taxes when they continue to hold those I Bonds they inherit from you. I Bonds aren’t eligible for a step-up in basis. They’ll pay federal income tax on the accumulated interest since your original purchase when they cash out or when the bonds mature. It’ll be taxed as ordinary income, not long-term capital gains. The interest is exempt from state and local taxes. TreasuryDirect will track and calculate the interest and generate the 1099-INT form for the new owner.

This is the easiest.

Optional – Pay Up In the Year of Death

After you die, your surviving spouse or whoever files your final year’s tax return can choose to include all the accumulated interest earned through your date of death on your final tax return. Then the second owner or the beneficiary will pay tax only on the interest earned going forward.

Your surviving spouse or the executor of your estate will need to do the calculation themselves if they choose this option. TreasuryDirect won’t generate any 1099 form unless they cash out your I Bonds.

Your second owner or beneficiary needs to keep the documentation to show how much interest was already added to your final tax return for the bonds they inherited. When they cash out the bonds or when the bonds mature, the 1099 form from TreasuryDirect will still show all the interest since your original purchase. They’ll have to remember to back out the interest that was already included on your final tax return. See IRS Publication 559 (page 11).

Because it can be many years until they cash out the bonds or when the bonds mature, it’s quite possible they’ll forget and they’ll pay tax again on the whole thing when they have a 1099 form in front of them. I think it’s better to just go with the default and not go out of the way to pay up in the year of your death.

Optional – Report Interest Every Year

Reader Jeff left this comment on my How to Buy I Bonds post:

Your comment on taxation is a bit misleading. Yes, you can wait until maturity to declare the interest in you income. However, you do have the option of declaring the interest annually on your tax return. In some cases that can be better, especially for younger buyers who don’t have much (or any) taxable income to report.

I admit I left that part out of the scope of the introduction to I Bonds because it’s more of an advanced tactic. Let’s go into it now.

IRS Publication 550 says this on page 7:

Method 2. Choose to report the increase in redemption value as interest each year.

You must use the same method for all Series EE, Series E, and Series I bonds you own. If you do not choose method 2 by reporting the increase in redemption value as interest each year, you must use method 1.

Method 1 is the default we talked about already — you wait until you cash out or until the bonds mature. Method 2 is appealing when you’re in a low tax bracket. You avoid having all the accumulated interest come as income in one year when you cash out or when the bonds mature. As Jeff mentioned, this is especially true when I Bonds are owned by a child, whose standard deduction and low tax brackets may otherwise go unused each year.

This optional Method 2 is doable in theory but it brings a lot of complications in real life.

No Annual 1099

You don’t get much help if you choose Method 2. It’s not like you can change a setting in your TreasuryDirect account and you’ll start receiving 1099 forms each year. TreasuryDirect will always assume you’re going with the default. You’ll have to figure out on your own how much interest to report each year.

No Periodic Statements

You see the current values of your I Bonds when you log in to your TreasuryDirect account. TreasuryDirect doesn’t produce any monthly or annual statements showing you the historical values and how much interest you earned during any month or year. When you’re doing taxes in March, it’s a small challenge just to figure out what the values were as of the beginning of this year or the end of last year.

Value on December 31 or January 1?

The IRS publication only says to report “the increase in redemption value” but it doesn’t say between which dates. Is it from January 1 to December 31? Or is it from December 31 of the prior year to December 31? Or is it from January 1 to January 1 of the following year?

The values on December 31 and January 1 are the same in most other financial instruments because January 1 is always a holiday. That’s not the case for I Bonds. I Bonds get the interest from the previous month on the first of each month. The redemption value on January 1 includes interest from December whereas the redemption value on December 31 does not.

If you count the increase using the values from January 1 to December 31 each year, you only include interest from 11 months. That can’t be right.

When it comes to taxes, the cutoff is usually December 31. If you use December 31 to December 31, you include interest from December of the prior year through November. That’s odd, but maybe that’s how they want it?

If you use January 1 to January 1, you include interest from January to December, but are you supposed to use January 1 of the following year as the valuation date?

After further research, reader Steven figured out that you should calculate “the increase in redemption value” using values on December 31 each year to report as interest on your tax return. See comment #7 under this post.

Unrealized Early Withdrawal Penalty

The redemption values you see in TreasuryDirect automatically exclude the potential three-month early withdrawal penalty when the bonds are within their first five years. It’s not clear whether “the increase in redemption value” is before this unrealized early withdrawal penalty or after.

When you have a bank CD, the interest is first paid, which you pay tax on, and you deduct the early withdrawal penalty if you withdraw early. If you use the redemption values of your I Bonds as shown by TreasuryDirect, you will have the early withdrawal penalty pre-deducted whether you actually withdraw early or not. You will have three fewer months of interest in the first year and 15 months of interest in the sixth year (instead of the normal 12 months). Again, that’s odd but maybe that’s how they want it?

Further research from Steven showed you should use the values on December 31 each year as reported by TreasuryDirect, with any early withdrawal penalty pre-deducted.

Bond-by-Bond Tracking Required

When you report interest annually, you make one entry on your tax return for all the I Bonds you own. When you finally cash out one of them, TreasuryDirect still assumes you’re going with the default and the 1099 form will include all the accumulated interest. You’ll need to back out all the interest you reported in previous years for that one bond you cashed out.

If you only rely on previous tax returns, (a) you’ll need to go back many years; and (b) getting the total for all bonds from previous tax returns isn’t enough. You’ll need the details bond by bond. If you only cash out part of a bond, you need to make further adjustments and also account for previous partial cashouts of the same bond.

If you use a tax preparer and you want them to track and report the interest every year, the extra cost required for this bond-by-bond tracking can easily overwhelm any tax savings from using the optional reporting method.

Risk of Paying Tax Twice

If you have been reporting interest every year and now someone else has to do your taxes for whatever reason, they may not know what was done before. It’s very easy to pay tax again when they have a 1099 form in front of them because that’s the default.

Savings Bond Calculator

If you really really want to take on reporting interest annually, it’s helpful to use the Savings Bond Calculator from TreasuryDirect. The calculator shows you the redemption value of an I Bond as of a given date.

The stand-alone calculator isn’t integrated into your TreasuryDirect account. Please read the instructions for how to save a list of bonds you own. Use Firefox or Safari when you save your list. It doesn’t work with Chrome or Microsoft Edge. You’ll have to update the list manually as you acquire new bonds and cash out old bonds.

Build and maintain a spreadsheet. Calculate the increase in redemption values using December-to-December values without any adjustment for the unrealized early withdrawal penalty during the first five years. Update the values in your spreadsheet with the values from the Savings Bond Calculator. Save screenshots of the Savings Bond Calculator as your documentation if necessary.

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Now you know why I left out the optional tax reporting method from the How to Buy I Bonds post. It’s much more complicated in real life than just that one sentence in the IRS publication. I’m not sure the juice is worth the squeeze. I happily go along with the default for my I Bonds.

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