• Taking the Tax Bite Out of Savings Bonds
  • June 18, 2003 | Author: Judith F. Todd
  • Law Firm: Sirote & Permutt, P.C. - Birmingham Office
  • The purchase of savings bonds has long been an American tradition. For many people, weekly or monthly reductions from their paychecks went directly to the purchase of these bonds. Traditionally, Series EE bonds have been purchased on a discounted basis and held for later redemption. One of the benefits of Series EE bonds is that interest earnings are not reported until the later of the date the bonds mature or the date they are actually redeemed.

    These bonds often sit forgotten in your safe deposit box for years. They have not been redeemed, they have not paid out interest to you and you have not reported the interest income on an annual income tax return. At your death, unless you have named a co-owner or designated a beneficiary on the bonds, they will be an asset that will pass to your beneficiaries under your will. If you do not report the interest annually during your life, and few people do, then the interest earned before death must be reported at your death in one of the following ways: your personal representative may elect to include all interest earned to the date of your death in your final personal income tax return, the estate could report all the income on its income tax return, or the estate could distribute the bonds to your beneficiaries and require the beneficiaries to report the income.

    You may find that these bonds are so old they have stopped earning interest. You may wish to redeem these bonds, but you will find that all of the accrued interest would be current income to you. It could result in a large income tax liability. However, you can exchange EE bonds for series HH bonds. This exchange allows you to continue to earn interest (and more importantly, defer any interest owed), but the exchange must be made within one year of your Series EE bonds ceasing to earn interest. At death, the incremental value of the old EE bonds, plus any interest paid on the HH bonds, but not received as of your date of death, must be reported on either your final income tax return or on your estate's income tax return. Another option is to wait until retirement to redeem these bonds, when you will presumably be at a lower income tax bracket.

    In addition to this income tax burden, savings bonds are part of your estate for estate tax purposes, subject to an estate tax rate of between 37% and 49%. There is an offsetting deduction against the income tax liability based upon any estate tax payable, but it is not a complete offset and some double taxation of the same bond will occur.

    Rarely do people specifically direct the disposition of their EE or HH bonds. Rather the bonds pass under the residuary provisions of the will to the beneficiary who takes the remainder of the estate. However, a specific bequest of your EE bonds to your favorite charity can avoid both estate and income taxes. The gift will reduce your taxable estate by the full value of the bonds, because the bequest will qualify for a charitable estate tax deduction. In addition, the income that is accrued over the years the bond has been held will be allocated to the charity, and since it is a tax-exempt entity no income tax will be due. Thus, the disposition of the bonds to a charity avoids both an estate tax and income tax on the same asset. This benefit can be accomplished by making a bequest of the bonds to a charity in your will or by making a direct gift of the bonds to a charity during your life.