Inherited bond may come with tax bill

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Dear Dr. Don,
I recently cashed a Series HH savings bond that was left to me by my aunt. I was named as a co-owner on the bond but wasn’t aware of it until after she died.

The bond had a face value of $1,000 and deferred interest of $777. The bond issue date is October 2002. The amount deposited was only for the face value of $1,000. What happened to the interest?
— Patricia Pecuniary

Dear Patricia,
The Treasury stopped issuing Series HH/H savings bonds in 2004. When they were issued, the bonds were available only in exchange for Series EE/E bonds or upon reinvestment of matured Series H bonds.

The deferred interest amount means that your aunt bought this bond in exchange for Series EE/E bonds. This purchase allowed her to continue to defer the income taxes due on the interest. When you cashed in the bond, the deferred interest income became taxable.

Unlike Series EE/E savings bonds, which are issued at a discount and grow by the amount of their interest earnings, Series HH/H savings bonds were issued at face value and pay interest semiannually. The coupon payments are taxable income in the year the interest is earned.

Ideally, you would have redeemed the bond in a month that it was scheduled to make a coupon interest payment, or no longer than a month prior to the coupon date. If so, you would have been eligible to receive the final coupon payment on the redeemed bond. However, it doesn’t sound like this was the case in your situation, as you say you only received the $1,000 face value of the bond.

The income tax bill due on the $777 in deferred interest will further diminish your inheritance unless the taxes on the deferred interest were paid out of your aunt’s estate. Here’s what the Treasury Direct Web page “Death of a Savings Bond Owner” has to say on the topic:

Upon death of one of two people named in a bond’s registration, any surviving person named on bonds as co-owner or beneficiary becomes the new owner. As the new owner, this person is required to include, on their tax return, the interest earned on the bonds for the year the bonds are redeemed or disposed of in a taxable transaction or the bonds reach final maturity, whichever occurs first.

Also, whoever files the deceased person’s final, individual, federal income tax return for the year that person died has the option of reporting all interest earned on the bonds up to the date of death.

So your aunt was receiving interest all along on the Series HH savings bond and there’s no hidden pool of interest waiting for you. You’ll probably owe taxes on the deferred interest, so I hope you haven’t spent all the proceeds from redeeming the savings bond.