You've Been Warned: Cashing Out Savings Bonds Younger Than 5 Years Will Cost You

People choose savings bonds because they offer simple guarantees backed by the government. Series EE bonds grow at a fixed rate and are guaranteed to double in value after 20 years, no matter what happens with rates. Series I bonds pay interest that adjusts for inflation every six months, helping your money keep up with rising prices. Yet, you can't cash out a Series EE or I savings bond in the first year. After that year, you need to wait another four before you can cash out without penalties to your interest earnings. Otherwise, the government will take away the last three months of interest you earned. So, if you cash out after 18 months, you really only get credit for 15 months of interest. 

Series EE and I bonds are both solid compound interest investments that build interest up every month. That interest gets added to your bond balance twice a year for up to 30 years. So, if you put $10,000 into savings bonds and the average rate you earned over two years is 4% per year, you'd make roughly $816 in interest. About $416 comes in the the second year. If you cash out after two years, you lose the last three months of interest. That would amount to $104 — a quarter of the second year's $416. That means you'd be left with $712 in this example, but the exact numbers will vary with each bond and rate.

No matter how long you wait to cash in an EE or I savings bond, the federal government will tax your interest. But if you don't want that, you can use the money for qualified college costs under the Education Savings Bond Program. If you cash in qualified EE or I bonds in a year when you're paying for higher education expenses like tuition or required fees for yourself, your spouse, or a dependent, you may be able to exclude some or all of the interest from your taxable income. 

You can also redeem the money and put it into a 529 savings plan, a tax-advantaged savings account specifically intended to pay for education. To claim the tax break, just file IRS Form 8815 with your tax return — though you should know why some people consider using a 529 plan to pay off student loans before you decide. 

If you want to avoid tax on your savings bond interest, you can also time your redemption for a year when your income is low, so tax credits or your standard deduction cancel out any tax owed on the interest. Or, you can choose to report the interest each year as it builds up, which spreads the tax over several years. If you inherit a bond, you can report interest earned before death on the deceased's final tax return, so you'll only pay tax on interest added after you inherited the bond, rather than the full amount.