The Inheritance Tax on US Savings Bonds

Savings bonds are an investment into the U.S. government. Investors loan money to the government and collect interest on it when the bond reaches maturity. Since savings bonds are considered a safe investment, many people not only purchase them, but bequeath them to heirs. Heirs may have to pay taxes on bond interest when they inherit savings bonds.

If the original bond owner didn't pay tax on the bond's interest before his death, sometimes the estate pays this tax. However, the estate is not obligated to, and if it doesn't the beneficiary must pay it. The beneficiary may pay this tax immediately or may wait until he redeems the bond. If he waits until redemption, he must pay tax on all interest from the bond at once.

Once the beneficiary receives the bond, she is responsible for paying taxes on all interest the bond earns from that point forward. As with the pre-death taxes, the beneficiary has two choices. She can either pay the tax now or pay it when she redeems the bond. If the beneficiary chooses to pay the tax now, she pays tax on that year's interest every year until the bond matures.

Who pays the taxes on interest accrued before death may depend on the relative tax brackets of the estate and the heirs. If the estate has sufficiently small assets, so that it will pay less taxes overall than the heirs, it makes more sense for the estate to pay taxes on bond interest so that heirs can receive a greater part of the investment. If the beneficiary is in a lower tax bracket than the estate, however, it doesn't make sense for the estate to pay the taxes.

The principal amount of an inherited bond -- the amount the decedent originally paid for the bond -- is never taxed. Only interest payments are taxed. This is because the Internal Revenue Service treats inherited bonds the same way it would treat them if the original bond holder were still alive. Thus, the beneficiary must pay the same taxes on the bond that the original holder would pay. Since the original holder would have to pay taxes on interest, the beneficiary has to pay these taxes as well.