Savings bonds allow owners to defer paying taxes on the accumulating interest until the bond is cashed in. After someone dies, the bond passes to the her estate or the person named as the beneficiary on the bond. How the bond is eventually taxed depends on how the decedent and her estate treated the accumulated interest.
Decedent Included Income
The interest accumulated on the savings bond won't be taxed when you cash in the bonds if it was included in the decedent's taxable income. This can be accomplished in two ways. First, the decedent may have been paying income taxes on the accumulated interest each year. Second, when the decedent died, the executor of the estate may have elected to include any of the accumulated interest in the decedent's last income tax return. For example, say the decedent bought a savings bond for $100 and it had grown to $180 when she died. If the decedent's executor elects to pay income taxes on the $80 of accumulated interest, the first $180 you get when you cash in the bond is tax-free.
Decedent Didn't Include Income
If the decedent didn't include any of the interest in her income and estate, you're responsible for paying taxes on the interest when you cash out the bond. For example, say she bought the bond for $100 and had deferred paying any taxes on the accumulated interest until the bond matured. If she dies before it matures and the executor doesn't elect to pay income taxes on the interest, you're responsible for all of the taxes.
Deduction for Estate Taxes
You can claim a deduction for the amount of estate taxes paid on the interest that was included in the decedent's estate but not the decedent's income. For example, say the decedent paid $100 for the bond and it was worth $180 when she died, but didn't include any of that interest in his income. When you cash in the bond, you can deduct any estate taxes paid on that $80 of interest. The write-off is classified as a miscellaneous deduction not subject to the 2-percent-of-adjusted gross income limit.
Any interest that accumulates after the decedent dies is always included in your income when you cash in the bond. For example, say you inherit a bond that the decedent bought for $100 and is now worth $180. If you cash it in for $200 years later, you will pay taxes on the last $20 of interest, even if the decedent paid taxes on the first $80 of interest.
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