Do Inherited Savings Bonds Get a Stepped-Up Basis?

Inherited savings bonds do not get a stepped-up basis. The accumulated interest on a Series EE or Series I bond is treated as income in respect of a decedent, which the tax code specifically excludes from the step-up rule. Whoever inherits the bond takes it at the decedent’s original cost and owes ordinary income tax on every dollar of deferred interest when the bond is finally cashed or reaches maturity. A few planning moves can soften that hit, but the underlying rule doesn’t bend.

Why the Step-Up Doesn’t Apply

Internal Revenue Code Section 1014 resets the basis of most inherited property to its fair market value on the date of death.¹ Inherit a stock bought at $20 that’s worth $100 the day the owner dies, sell it at $100, and there’s no taxable gain. That’s the shelter people expect from an inheritance.

Savings bonds don’t work that way because they don’t grow through market appreciation. Their value increases through interest that accrues over time, and most owners let that interest compound untaxed year after year rather than reporting it annually. When the owner dies without ever reporting it, the IRS classifies that unreported interest as Income in Respect of a Decedent — income the deceased had earned but never picked up on a return.²

Section 1014 carves IRD items out of the step-up rule, and the IRS confirms in Publication 559 that U.S. savings bonds acquired from a decedent are a specific type of IRD.³ The beneficiary inherits at the decedent’s cost, and all the accrued interest stays taxable as ordinary income on the return of whoever eventually redeems the bond.

The Executor’s Election to Shift Pre-Death Interest

Before the beneficiary is stuck with the whole tax bill, the executor has a lever worth pulling in the right circumstances. The executor can elect to include all interest accrued through the date of death on the decedent’s final Form 1040.³ Once made, the election is irrevocable.

The reason to do it is rate arbitrage. If the decedent had low income in the year of death, or unused deductions, the pre-death interest gets taxed at the decedent’s low marginal rate instead of the beneficiary’s higher one. Someone who died in January with almost no income for the year might be in the 12% bracket while the beneficiary is in the 24% bracket. Running $30,000 of accumulated bond interest through the lower return is a real savings.

After the election, the beneficiary’s basis in the bond increases by the amount reported on the final return. From that point on, the beneficiary only owes tax on interest that accrues between the date of death and redemption, and that post-death interest keeps its tax-deferred status until the bond is cashed or matures.³

The trade-off is that the estate pays now. When the decedent’s final-year rate is close to the beneficiary’s, the election isn’t worth the paperwork. When there’s a real gap, it usually is.

What the Beneficiary Can Do

If the executor didn’t make that election, the bond passes to you with all the deferred interest still attached. You have two ways to handle it.

Keep Deferring

You can hold the bond and let interest continue to accrue without paying tax on it until you redeem it or it hits its 30-year maturity date.⁴ This works if you expect to be in a lower bracket later, for instance after retirement. One catch: at maturity, the IRS treats all the interest as received in that year whether you actually cash the bond or not.⁵ Waiting past maturity doesn’t buy more deferral, only lost interest.

Cash Out

Redeeming the bond triggers tax on all accumulated interest, including the portion that built up during the decedent’s lifetime. That interest is ordinary income at your marginal rate, not the lower long-term capital gains rate.⁶ You report it on Form 1040, and you’ll need Schedule B if your total interest income for the year is over $1,500.⁷

Watch for bracket creep. Bonds that have compounded for decades can carry enough interest to push a single year of income into a much higher bracket. If you’ve inherited several bonds, spreading redemptions across tax years usually keeps more of the interest at lower rates than cashing everything at once.

Fix the 1099-INT So You Don’t Pay Twice

When you cash an inherited bond, the 1099-INT you receive shows all the interest the bond earned over its entire life. It is not reduced by anything the decedent already reported or anything the executor picked up on the final return.⁸ If you just copy that number onto your return, you’ll pay tax on interest that was already taxed.

The IRS wants you to use the nominee procedure on Schedule B. Report the full 1099-INT amount on Line 1, then subtract the interest already reported on the decedent’s final return with a note identifying the adjustment. Only the net figure carries through to your taxable income.⁹ Keep a copy of the decedent’s final return showing the interest as backup if the IRS asks about the discrepancy.

TreasuryDirect puts it directly: “If you are the new owner who gets that 1099-INT, you must prove to the IRS that a portion of the interest was previously reported to a different owner.”⁶ The burden is on you.

The Estate Tax Deduction Under Section 691(c)

If the estate was large enough to owe federal estate tax, the accrued bond interest was already counted in the taxable estate. Without relief, those same dollars would be taxed twice: once by the estate and again as ordinary income to you. Section 691(c) lets the beneficiary deduct a proportional share of the federal estate tax attributable to the IRD items.¹⁰

You claim it as an itemized deduction on Schedule A in the same year you report the bond interest.³ The calculation compares the actual estate tax paid to what it would have been without the IRD items and allocates the difference to the interest you’re reporting. Most people bring a tax professional in for this one.

The practical limit: this deduction only helps when federal estate tax was actually paid. The federal estate tax exemption sits at $15 million per person, so most estates don’t trigger any estate tax and there’s nothing to deduct.

Two Boundaries Worth Knowing

The higher education exclusion under Section 135 does not transfer to a beneficiary. The exclusion requires that the person redeeming the bond be the original purchaser (or their spouse) and that the purchaser was at least 24 when the bond was issued.¹¹ A grandchild who inherits bonds and uses them for tuition still owes the tax. If education is the goal, the bond owner has to redeem and pay the qualified expenses while alive.

On the other side, savings bond interest remains exempt from state and local income taxes, and the exemption follows the bond to the beneficiary.⁶ In a high-tax state, that’s worth a few percentage points compared with inherited investments whose gains are taxed at both levels.

1
Office of the Law Revision Counsel. 26 U.S.C. 1014 – Basis of Property Acquired From a Decedent
2
eCFR. 26 CFR 1.691(a)-1 – Income in Respect of a Decedent
3
Internal Revenue Service. Publication 559, Survivors, Executors, and Administrators
4
eCFR. 31 CFR 351.5 – What Is the Maturity Period of a Series EE Savings Bond
5
TreasuryDirect. Comparing EE and I Bonds
6
TreasuryDirect. Tax Information for EE and I Bonds
7
Internal Revenue Service. Savings Bonds 1
8
Internal Revenue Service. Publication 550, Investment Income and Expenses
9
Internal Revenue Service. Instructions for Schedule B (Form 1040)
10
Office of the Law Revision Counsel. 26 U.S. Code 691 – Recipients of Income in Respect of Decedents
11
Office of the Law Revision Counsel. 26 U.S. Code 135 – Income From United States Savings Bonds Used to Pay Higher Education Tuition and Fees