U.S. Savings Bonds

The interest paid on U.S. savings bonds is exempt from tax at the state and local level and is subject to federal tax only when it is actually paid out to the bondholder, not when it is accrued. Interest payments differ, depending on the type of bond. Interest on Series H bonds is paid semiannually and is subject to federal tax then. By contrast, Series EE and Series I savings bonds accrue interest monthly throughout their maturity periods, but the interest is paid--and therefore is taxable--only when the bond is redeemed or when it reaches final maturity after 30 years. Interest on savings bonds is exempt from federal tax only if the person redeeming a bond uses the funds to pay qualified education expenses (generally tuition and fees) and satisfies other restrictions.

Series H savings bonds are no better than ordinary savings as a way to accumulate retirement funds. By contrast, Series EE and I bonds, which are similar to nondeductible traditional IRAs, contain a tax incentive that encourages saving for retirement: bonds are purchased with after-tax income, and the taxes on interest are deferred until the bonds are redeemed. The bonds and the IRAs differ in four ways, however. First, savings bonds can be redeemed without penalty at any time after they have been held for six months, so they provide greater flexibility than savings held in IRAs do. Second, interest on savings bonds is exempt from state and local taxes, whereas those taxes apply to earnings on IRAs when they are withdrawn. Third, savings bonds lose their tax-deferral advantage 30 years after they are issued; there is no time limit for deferring tax on IRA earnings. Fourth, unlike nondeductible IRAs, savings bonds need not be redeemed once the owner turns 70½ (although they must be redeemed after 30 years).