While savings bonds do not earn high interest, the low interest rate is sometimes compensated by favorable tax terms. Remember, you can use the money you do not spend on taxes to purchase an item you want or to invest in other instruments.
What specifically are the tax advantages? For starters, you do not pay any state or local taxes on the earnings of any savings bonds you own—ever. While you must pay federal taxes on the earnings of Series HH bonds in the year that you receive that interest, you can defer earnings and taxes on Series E, EE, and I bonds for long periods.
The Education Bond Program exempts savings bond earnings from federal tax if the bonds are redeemed to pay for qualified education expenses.
Remember, you can hold Series EE and I bonds for 30 years. After that period, you can exchange Series EE bonds for Series HH bonds and then hold them for another 20 years. After 20 years, you must redeem the HH bonds and finally pay any taxes owed on the earnings from the old EE bonds. Note: Series HH/H bonds have no longer been available for sale or exchange since August 2004.
If you buy Series EE or Series I bonds in the name of your child and redeem the bonds while the child is still your dependent, you will pay taxes on the earnings at the child's rate. The child's rate may be 0 percent if the child's total unearned income is $850 or less; in any case, it is almost certainly less than your tax rate.
In 1990, the Treasury Department established the Education Bond Program, which exempts savings bond earnings from federal tax if the bonds are redeemed to pay for qualified education expenses. To qualify for this program, an adult age 24 or older must buy the bonds. He or she then must redeem them and document tuition and certain other education-related expenses. (Room, board, and books are not qualified.) If the value of the bonds redeemed is greater than the qualified expenses, only the proportion used for qualified expenses is tax-free.
The full exclusion is also only available to taxpayers with annual incomes that meet the thresholds below:
Within these limits, the exclusion is gradually phased out. You can find more information about the program at the Savings Bonds for Education Website).