U.S. Government Obligations

Interest on all federal government bonds is generally taxable for federal income tax purposes, but it is tax-free for state and local income tax purposes.

Generally, interest on treasury notes and bills is paid either at maturity (for instruments with a maturity of one year or less) or at six-month intervals. You must report it in the year you receive it.

There is a special rule for Series I or EE U.S. Savings Bonds. While interest on these bonds accrues each year, if you're a cash-basis taxpayer, you don't have to pay tax on the interest until you cash in the bond, and most people choose to go this route. However, you do have the option of reporting and paying tax on this interest each year, if you want to avoid a big tax bill in the final year or if you think you'll be in a higher tax bracket at that time.

If you've been accruing interest on savings bonds without reporting it, you can switch to the annual reporting method without seeking IRS permission, but you'll have to switch for all bonds you own, and you'll have to report and pay tax on all interest owed on all bonds to date. You can also switch back to the "postpone recognition of interest" method later, but you'll have to write to the IRS for permission in that case.

Save Money

If your minor child was given U.S. savings bonds at birth or soon thereafter and you haven't been reporting annual interest, you might think about switching to the "annual reporting" method in the year your child turns 18. For that year and all later years, the child's interest income will no longer be taxed at the parent's (usually higher) tax rate. Since savings bonds generally mature in 30 years, your child will probably be in a lower tax bracket at age 18 than he or she will be at age 30 or 31 when the bond is cashed, and under the annual reporting method, a minimum of about half the interest will be taxed at the lower age-18 rate.

Also, there is a special tax break for savings bonds redeemed to pay for higher education expenses.

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