A U.S. savings bond is an investment in the Treasury of the United States and guaranteed by the full faith and credit of the federal government. Because savings bonds pay interest when redeemed, any accrued interest beyond the purchase price is subject to federal income tax but not state or local taxes.
Sales and Income Taxes
According to the Internal Revenue Service, any interest earned on a U.S. Treasury bill "is exempt from all state and local income taxes." Therefore, any interest income realized on the sale of a bond is not included in your annual state tax liability. This exemption also precludes states, counties and municipalities from imposing sales taxes on the purchase of savings bonds.
Other State Taxes
Savings bonds are taxable under state inheritance, gift and estate taxes. Gift and inheritance taxes require the recipient of a bond that is given as a present or bequeathed in a will to pay a percentage of the bond's value to the state. An estate tax is imposed on the legal estate of the recently deceased savings bond holder, based on the value of all assets at the time of death.
Deferred Federal Taxes
The interest rates for savings bonds are adjusted twice a year, in May and November. Although the interest is earned and added to the value of the bond holder's account continuously, this earned income is not taxable until a bond is redeemed. This defers any federal income tax debt until after the sale of the bond.
The exemption from state and local taxes is because federal activities are immune from the taxation powers of the states due to federalism. This is a principle set forth in the U.S. Constitution that creates separate government powers and immunities between the federal and state governments. Likewise, interest income from many state or locally issued municipal bonds are exempt from federal taxes.
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- savings bonds image by Stephen VanHorn from Fotolia.com