US Savings Bonds & Original Issue Discount

Understanding the tax treatment of US Savings Bonds and Original Issue Discount (OID) is essential for EA exam success. These instruments have unique reporting requirements that differ from regular interest income.

---

Series EE Savings Bonds

Series EE bonds are low-risk savings bonds issued by the US Treasury. Taxpayers purchase them at face value (not at a discount), and they earn a fixed rate of interest that compounds semiannually.

Key Features of Series EE Bonds

20-Year Guarantee

The Treasury guarantees that Series EE bonds will double in value at the 20-year mark. If the stated interest rate is too low to achieve this, the Treasury makes a one-time adjustment at 20 years to bring the bond to exactly twice its purchase price.

Example: If you purchase a $10,000 EE bond and the fixed rate only grows it to $18,000 by year 20, the Treasury automatically adjusts the value to $20,000.

---

Series I Savings Bonds

Series I bonds protect against inflation by combining a fixed rate with an inflation rate that adjusts every six months based on the Consumer Price Index (CPI-U).

I Bond Rate Structure

The composite rate for I bonds combines two components:

1. Fixed Rate — Set at purchase, never changes for the life of the bond
2. Inflation Rate — Adjusts every May 1 and November 1 based on CPI-U

I Bond Purchase Limits (2024)

• $10,000 in electronic I bonds per SSN per calendar year (via TreasuryDirect)
• $5,000 in paper I bonds using a tax refund (Form 8888)
• Total possible: $15,000 per person per year

Redemption Rules

• Minimum holding period: 12 months (cannot redeem before 1 year)
• Early redemption penalty: Forfeit 3 months of interest if redeemed before 5 years
• After 5 years: No penalty for redemption

---

Series EE vs. Series I Bonds Comparison

---

Tax Treatment of Savings Bonds

Two Methods for Reporting Interest

Taxpayers have two options for reporting savings bond interest:

1. Cash Method (Default) — Report interest when the bond is redeemed or matures
2. Accrual Method — Report interest annually as it accrues

Most taxpayers use the cash method because it defers taxes until redemption. However, once you elect the accrual method, you must use it for all savings bonds and continue using it in future years unless you receive IRS permission to change.

State Tax Exemption

All US savings bond interest is exempt from state and local income taxes. Only federal income tax applies.

---

Education Savings Bond Program (Form 8815)

The Education Savings Bond Program allows taxpayers to exclude interest from income when using Series EE or I bonds to pay for qualified higher education expenses.

2024 Eligibility Requirements

2024 MAGI Phase-Out Ranges

The exclusion phases out based on Modified Adjusted Gross Income:

Married Filing Separately taxpayers are not eligible for this exclusion.

Claiming the Exclusion

Use Form 8815 to calculate and claim the exclusion. The excludable amount is limited to the portion of bond proceeds used for qualified expenses.

---

Original Issue Discount (OID)

Original Issue Discount occurs when a bond is issued at a price below its stated redemption price at maturity. The difference between the issue price and redemption price represents imputed interest that must be recognized over the life of the bond.

OID Example

A 10-year bond with a $1,000 face value is issued at $920. The $80 discount is OID that must be accrued and recognized as interest income over 10 years, even though the bondholder receives no cash until maturity.

Form 1099-OID

Issuers report OID to bondholders on Form 1099-OID. The bondholder includes this amount as interest income on Schedule B, even though no cash was received.

---

De Minimis OID Rule

The de minimis rule allows taxpayers to treat small amounts of OID as zero for tax purposes. This simplifies reporting for bonds with minimal discount.

De Minimis Threshold Formula

De Minimis OID = 0.25% x Stated Redemption Price x Years to Maturity

If the actual OID is less than this threshold, the bondholder can ignore the OID for annual accrual purposes.

De Minimis Example

A 10-year bond has a stated redemption price of $1,000 and was issued at $980 (OID of $20).

Threshold calculation: 0.25% x $1,000 x 10 years = $25

Since the $20 OID is less than the $25 threshold, the de minimis rule applies. The bondholder does not accrue OID annually. Instead, the $20 is treated as capital gain when the bond is sold or redeemed.

---

Treasury Inflation-Protected Securities (TIPS)

TIPS are Treasury securities with principal that adjusts based on changes in the Consumer Price Index. While TIPS protect against inflation, they create a unique tax situation.

The Phantom Income Problem

TIPS holders must pay federal income tax on inflation adjustments to principal in the year they occur — even though they do not receive this additional principal until maturity. This is called "phantom income" because taxes are due on income not yet received.

TIPS Tax Reporting

• Form 1099-INT reports semiannual coupon interest payments
• Form 1099-OID reports the inflation adjustment to principal (the phantom income)

Strategy: Tax-Advantaged Accounts

Because of the phantom income problem, many investors hold TIPS in tax-deferred accounts (IRAs, 401(k)s) to avoid paying taxes on income they have not received.

---

Key Differences: OID vs. Savings Bonds

---

Summary

• Series EE bonds earn a fixed rate and are guaranteed to double at 20 years
• Series I bonds earn a composite rate that adjusts for inflation semiannually
• Both bond types have a $10,000 annual purchase limit per SSN (I bonds allow $5,000 additional paper bonds via tax refund)
• The Education Savings Bond Program excludes interest used for qualified education expenses (2024 MAGI phase-out: $96,800-$111,800 single; $145,200-$175,200 MFJ)
• OID must be accrued annually unless the de minimis rule applies (OID < 0.25% x face value x years)
• TIPS create phantom income from inflation adjustments that is taxable before receipt