Savings bonds are an attractive investment because a taxpayer has the option of deferring paying interest on the bonds until he cashes in the bonds or the bonds mature, which is the cash method, or he can report the interest as it accrues each year on his income tax, which is the accrual method. However, this benefit can cause complications when the bond owner dies. Knowing the estate's options for including the interest in the decedent's final income tax return can help you minimize the resulting tax bill.
Determining the Beneficiary
The person who inherits the savings bonds of a decedent depends on who is listed as the beneficiary on the bond, the decedent's will and whether the decedent elected to have the bonds payable upon his death. If the decedent elected to make the bonds payable upon his death, the estate must cash the bonds and then distribute the proceeds according to whoever is the named beneficiary. If the bonds were not payable upon death, the bonds go to the named beneficiaries. If no beneficiaries are named for the bonds, the bonds become part of the decedent's estate.
While taxpayers may elect to include the interest on a savings bond that accrues each year in their income taxes, most people select the default option of deferring any income taxes on the bonds until the bond is cashed in. When a bondholder who was claiming the interest income each year dies, the estate must include any accrued interest up to the date of death on the decedent's final income tax return. Any interest earned after the date of death is taxable to the beneficiary who receives the bonds.
Decedent-Deferred Interest Income
When the bond owner who has been deferring the interest on the bond dies, the executor of the estate has the option of including any interest that has accrued to that point as part of the decedent's final return. If this option is selected, the beneficiary only pays taxes on the interest earned after the decedent's death. However, if the executor of the estate does not include the income on the decedent's final income tax return, all the interest on the bond, including the interest that accrued while the decedent was still alive, becomes the income of the beneficiary inheriting the bond.
Using Bonds for Legacy Payments
If a bond does not have a specific beneficiary and the estate uses it to make a legacy payment of a specific amount, the interest up to the transfer to the beneficiary is taxable on the decedent's final return. If the bond accrues additional interest between the time the decedent dies and the estate cashes the bond, the additional interest is taxable to the estate. For example, if the decedent left $10,000 to Jorge and the bond being used for the legacy payment had accrued $1,000 of interest at the time of the decedent's death plus an additional $200 of interest before it was cashed, the $1,000 of interest is taxable on the decedent's final return and the $200 of interest is taxable to the estate.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."