The interest on savings bonds is taxable at the federal level but not at the state or local level. There are many kinds of United States Treasury bonds, including savings bonds that are labeled Series EE or Series I. Series E is an older version of Series EE, and no longer pays interest. The government uses different methods to compute the interest paid on the two series, each with its own fixed rates. Series EE is a fixed interest rate accrual bond, while Series I is an accrual bond that earns a fixed rate plus a variable inflation rate, based on the Bureau of Labor Statistics index called the consumer price index – urban (CPI-U).
An accrual bond is one in which the interest is added to the value of the bond and paid when the bond is cashed. Federal tax on the interest on savings bonds may be paid semi-annually, annually, or when the bond is cashed, at the election of the tax payer. Series EE bonds are purchased at 50% of full face value if paper bonds are chosen, but at full face value if purchased electronically. In practice, this means the purchaser will buy a $100 US dollar (USD) paper bond for $50 USD, or a $50 USD electronic bond for $50 USD, both worth $100 USD at maturity. Series I bonds are purchased at full face value without respect to the manner of purchase.
Both Series EE and Series I bonds are 30 year maturity bonds. The reason Series I bonds are always purchased at face value is that the inflation rate is unknown and subject to markets, thus the final value of the bond cannot be predicted accurately. Both series of bonds must be held for 12 months before they can be redeemed. If the bond holder cashes the bond during the first five years, he will be penalized three months' interest. Both bonds may be used in a program to finance education, and in this case the interest on savings bonds is forgiven.
The US Treasury offers another inflation protected bond, the Treasury Inflation-Protected Security (TIPS) bond. Someone wishing to buy savings bonds, especially if there is a possibility of using the savings bonds for education, should be sure to buy Series I bonds, not TIPS. Unlike Series EE and Series I bonds, interest paid in the TIPS program is taxable even when used for education.