Q: I own U.S. savings bonds that will no longer earn interest in 2015. My question is: If I cash them in, is there any way I can avoid paying tax on that interest? I would like to give the money to my three children, but I cannot afford to pay taxes on a large amount. I am an 80-year-old widow on a fixed income. Thank you.
A: Under most circumstances, you cannot avoid paying tax on the interest you receive when you cash in U.S. savings bonds. Assuming you did not elect to report the accrued interest on the bonds each year, you must report the interest at the earlier of the date the bond matures or the date you cash it.
There is a special rule for Series E bonds that allows you to defer paying tax on the interest if you purchase another U.S. government obligation or make a tax-free exchange into another nontransferable U.S obligation. Series E bonds were last issued in 1979 with 30-year maturities, so chances are you do not hold any of them if your bonds mature in 2015. You probably own Series EE, HH, or I bonds. There are no current tax-free exchanges of EE, HH or I bonds. EE bondholders used to be able to exchange them for HH bonds, but the government stopped issuing HH bonds.
Under certain circumstances, Series EE bonds can be cashed and the interest excluded from income. If an adult over age 24 purchases EE bonds, which are registered in their name or their name and the name of a child, and later cashes the bonds and uses the proceeds to pay for qualified higher education expenses for the bond owner, their spouse or dependent, the interest on the bonds is not taxable. Qualified higher education expenses are limited to tuition and required fees at eligible institutions. There is an income limit on this exclusion. In 2012, single taxpayers with income over $72,850 started to lose the benefit of the exclusion. No exclusion was available if income exceeded $87,850. For married taxpayers filing joint returns the phase-out range was $109,250 to $139,250.
It appears that making a gift of a U.S. savings bond triggers the recognition of the accrued interest as of the transfer, unlike some other assets. So it does not appear to be possible to shift the unrecognized income to another person by gifting the bonds. If you change the name on the bonds to another person, the interest becomes taxable to the original owner.