U.S. Savings Bonds used to be such a conservative investment that the tax angles were among the least of the concerns of people who bought them. Now, savings bonds are more competitive. They have shed the fixed, well-below-market interest rate of the past. And, compared with the low yields on some bank accounts and money market mutual funds, the still skimpy yields on savings bonds don't look so bad.
Until mid-2005, Series EE bonds were sold for half of their face value and earned interest at a rate that fluctuates with market interest rates. Now, the bonds are still sold for half their face value but the rate in force when you buy the bond does not change. A bank selling the bonds can tell you the current rate or check out the savings bond web site http://www.treasurydirect.gov/indiv/products/products.htm.
Whether the rate is fixed or floating, Series EE bonds have two basic tax appeals. The interest earned is exempt from state and local income taxes, which means the earnings are worth somewhat more to you than interest that would be taxed. (If you face a state tax rate of 7%, for example, the tax-exempt status makes a 3.5% savings bond yield worth about the same as a fully taxable 3.76% yield.)
Second, you can put off the federal tax bill on the interest until you cash the bonds. Such tax-deferred interest is advantageous because funds that otherwise would go to the IRS can remain invested for further growth.
The tax-deferred nature of Series EE bonds has made them an attractive tool for a child's savings plan. You, or some other generous soul, can buy bonds for your children, and the investment will be permitted to grow untaxed by the IRS until the bonds are cashed. As long as the child is named owner of the bonds, he or she will be responsible for the tax bill, even if the parent or other purchaser is named the beneficiary. However, if you name yourself co-owner of the bond, you will be liable for the tax bill even if the child cashes the bond.
Because tax on the bonds is deferred until they are cashed, the annual earnings do not count for purposes of the "kiddie tax" discussed in Tax Tips for Children and investment income. As long as the bonds are cashed in or after the year the child reaches age 18, the interest will be taxed in the child's bracket rather than the parents'.
In some cases, though, it may make sense to skip the tax deferral and report the income each year as it builds up. If your child has a limited amount of income, this maneuver may effectively make part or all of the savings-bond interest completely tax-free. Annual reporting of the interest could be advantageous if the child's total income is so low that no tax would be due. In 2006, a child can have up to $850 of investment income tax-free, and an additional $850 is taxed at his or her own rate without triggering the kiddie tax.
To report the interest annually, simply file a tax return for the child for the first year he or she owns bonds and show the amount of interest that accrued during the year. Banks that sell bonds should have a table showing how much was earned by bonds purchased at different times during the year. You don't have to file another tax return until the child's income is high enough to require one.
If you have been using the annual reporting method but are tripped up by the kiddie tax—because income you thought would be taxed in your child's low bracket is now being taxed in yours—you can switch back, deferring the tax bill until the bonds are cashed. To do so, you file Form 3115, Application for Change in Accounting Method with the IRS, and defer the tax on future earnings until the bonds are cashed. TaxCut does not include that form, but you can get a copy by calling the IRS at 1-800-TAX-FORM or you can download it from the IRS website: http://www.irs.gov/pub/irs-pdf/f3115.pdf.)
When savings bonds are cashed, the owner will receive a 1099-INT form showing as income the difference between the purchase price and redemption value of the bonds. If you have reported some or all of the interest annually, however, you don't have to pay tax on that amount. You do have to report the full amount of interest but also get to subtract the amount that was reported in earlier years. With TaxCut, enter the amount shown on the 1099-INT on the Interest Income Worksheet and then, check the box stating you need to make an adjustment. Choose this option: My U.S. Savings Bond interest is too high. On the next screen you can enter the amount that needs to be subtracted. Clearly, you must maintain careful records over the years to prevent you, or your child, from overpaying the tax bill.
Bonds purchased in 1990 and later years can be an even better vehicle for college savings. The interest can be totally tax free if the money is used to pay tuition or invest in either a Coverdell ESA or a 529 college savings plan.
Assume, for example, that you redeem $10,000 worth of bonds, an amount that includes $5,000 in interest built up over the years. In the 28% bracket, that $5,000 would cost you $1,400 in added income tax. However, if you qualify for this break and spend the $10,000 on a child's college bills, you avoid that tax bill. Basically, the $1,400 is Uncle Sam's contribution to the tuition.
Unlike the basic savings bond strategy, to qualify for this break the student cannot own the bonds. They must be purchased and owned by the parents, who must be at least 24 years old when the bonds are purchased. The interest is tax-free if, in the year you redeem the bonds, you also pay qualifying educational expenses—basically, that's tuition and fees for a dependent child or contributions to a college fund.
If you pay $10,000 in tuition and fees and redeem bonds worth $10,000 or less, for example, all interest would be tax-free. If you redeemed $10,000 worth of bonds and paid just $7,500 for a child's tuition and fees, however, just 75% of the interest would be tax-free.
Note this: The tax break disappears at higher income levels. For 2006, for example, the right to exclude bond interest is phased out as adjusted gross income on a joint return rises between $94,700 and $124,700. For single parents, the 2006 phase-out range is $63,100 to $78,100. If your AGI on a 2006 joint return is halfway through your phase-out zone, for example, just half of the savings bond interest would be tax-free The phase-out ranges are supposed to increase each year to account for inflation.
Remember that your eligibility for this tax break is determined by your income when you redeem the bonds—perhaps many years in the future—rather than when you buy them. Assuming a 3% annual inflation rate, in 18 years—when today's newborn is ready to go to college—the phase-out range on joint returns would begin at approximately $160,000.
Savings bonds purchased before 1990 don't qualify for this tax break, which raises the question: Would it make sense to cash in older bonds and invest the proceeds in these new tax-free education bonds? Probably not. Although it's legal, you're threatened by a triple whammy: Tax would be due on the interest that has built up while you owned the older bonds; you could be hit with an interest penalty on bonds cashed during the first five years of ownership; and the new bonds might pay less interest. Bonds purchased before November, 1986, for example, carry a guaranteed minimum interest rate of 7%; bonds purchased now carry no minimum guarantee at all.
Some parents may discover an added benefit to registering bonds in their own names rather than the child's name, as required under the old tax-saving method. When the student owns the bonds, it's really up to him or her how to spend the money, be it on college bills, a new car or a "learning experience" in Paris. With the new rules, the parent controls the cash, and the tax break comes only if it's used to pay for college. If you cashed in eligible bonds during 2006, go through the Interview for Education Bonds and TaxCut will generate the required Form 8815 for you.
What if you inherit Series E or EE bonds? First of all, forget the general rule that inheritances are tax free. The IRS demands that someone pay tax on the interest that has built up, but doesn't care whether you or the deceased owner foots the bill. Even if the bonds are not redeemed, the untaxed interest can be reported on the decedent's final tax return. In that case, you would be responsible for the tax only on the interest earned after the date of death of the previous owner.
If the interest isn't reported on the deceased's final tax return, you assume the tax liability along with ownership of the bonds. When you cash in the bonds, you will report and pay tax on all the interest. The choice turns on the tax rate that would apply if the interest were reported on the decedent's final return as opposed to yours and on how long you are likely to hold on to the bonds—and therefore how long you will hold off the tax bill if you assume the liability.
The I Bond is an inflation-indexed security. It pays a lower stated interest rate than EE bonds but its value is increased to keep up with inflation. In the fall of 2005 when EE bonds were paying 3.5%, for example, the I Bond rate, including the inflation kicker, was 4.8%. These bonds have the same advantages as regular saving bonds, including the fact that the tax liability can be put off until the bonds are cashed or, if you choose, it can be reported annually. If you choose annual reporting, you must report both the stated interest earned and the amount by which the bond value increases to keep up with inflation as interest. Also, interest on bonds held in the parents' names can be totally tax free if used for college.