Owners of savings bonds also receive tax advantages. The interest is exempt from state and local income tax. Savings bonds are issued by the U.S. Treasury Department so they enjoy this tax treatment, along with all Treasury bills, notes, and bonds.
Moreover, individual owners of savings bonds can defer the tax on that interest as long as the bonds aren't cashed in.
Example: John Smith buys a $100 I Bond (an inflation-protected savings bond) as a birthday gift for his newborn niece, Kaylyn Jones. Buying online at www.treasurydirect.gov, he pays face value for a $100 bond.
Kaylyn puts away the bond until age 36, when she decides to cash it in. She redeems the bond then for $400, which represents an annualized return of around 4%. Kaylyn reports a $300 gain on the bond and owes tax at ordinary income rates. Because Kaylyn will be established in her career by then with a substantial income, she'll owe tax at a high rate. Although Kaylyn's actual tax bill is modest in this example, an individual taxpayer who cashes in a large amount of savings bonds in one year could owe a significant amount of tax.
When a child owns a savings bond, the parents may prefer to pay the tax each year rather than defer the tax. In the Kaylyn Jones example, the annual income might be around $4 or $5 a year while she is a youngster. As long as Kaylyn has little or no taxable income, the tax bill will be scant.
A parent can make this choice for a child at any time. To do so, you file a tax return for the child and report all the interest earned on the bonds from the date of their acquisition through year-end that has not previously been reported. You'd also state on the return that your child chooses to report the interest each year. Be sure to keep a copy of this return indefinitely. If your child is not required to file a tax return for any year after making this election, he or she does not have to file a return just to show the annual accrual of U.S. savings bond interest. Public Debt Form 3501, available at www.treasurydirect.gov, shows annual interest on savings bonds, which will help you keep track of interest accruals. You'll include the annual interest on the child's tax return in any year that he or she is required to file one.
This strategy is not necessarily limited to children who own savings bonds. A taxpayer who finds himself in a low tax bracket in a given year might choose to pay tax on accrued savings bond interest at that time if he expects to return to a higher bracket in the future. When you make such a payment, you're electing to pay tax each year on all savings bonds you own as well as any purchased in the future. You can, however, revoke this election and go back to deferring interest income by attaching a statement to a future tax return.