A U.S. savings bond is a government bond offered to U.S. citizens to purchase which in turn helps fund federal spending. In exchange, the U.S. savings bond provides the investor with a guaranteed return backed by the federal government. Although the return on investment is far less than other opportunities on the uncertain market, they are nevertheless considered extremely safe and therefore attractive for financial planners looking for sure things. U.S. savings bonds are not transferable on the open market and can only be purchased directly from the U.S. Treasury. Investors can buy bonds with a minimum investment value of $25.00 up to a maximum value of $10,000.00 in a calendar year.
Currently, the U.S. government offers Series EE bonds and Series I bonds to individuals for purchase:
- Series EE Bonds: These bonds are sold at their face value and mature to their full value after 20 years. They accrue a fixed rate of interest that is paid at maturity or redemption.
- Series I Bonds: These bonds are sold at their face value and mature to their full value after 30 years. They accrue at a variable rate of interest adjusted for inflation that is paid at maturity or redemption.
In addition, taxpayers may still be holding Series HH bonds that were last offered in 2004 with a 20 year maturity period. Some taxpayers may even possess Series E bonds that were last issued in 1980 with a 30 year maturity period.
U.S. savings bonds cannot be cashed in until at least 12 months after purchase, but the longer that the bond is held the more interest it accrues. No matter what U.S. savings bond is held, taxpayers have a duty to report the interest income on their federal tax returns. When this interest must be reported depends on whether the taxpayer uses the cash method or the accrual method for accounting as far as IRS records are concerned:
- Accrual Method – Accounting method where revenue or expense are recorded when a transaction occurs instead of when payment is received or made. For example, if a lawyer retains a client for representation and charges a flat fee of $5,000.00, but does not receive the funds until the end of the case, the $5,000.00 payment is recorded at the time of retention, not payment. If you use the accrual method, you must report interest on U.S. savings bonds EVERY YEAR as it accrues. You cannot postpone reporting interest until you receive it or until the bond matures.
- Cash Method – Accounting method where payments are recorded during the tax period they were received, and expenses are recorded during the tax period they were paid. If you use the cash method, you can report interest in one of two ways:
- Option 1: Choose to report the increase in redemption value as interest each year.
- Option 2: Postpone reporting the interest until the tax year you cash or dispose of the bonds or the year in which they mature, whichever happens earlier.
Unlike other investments such as stock shares or bank account interest, the money you earn on U.S. savings bonds is taxed at ordinary income rates, NOT the lower capital gains rates. The interest is incorporated into your gross income and is taxed at the same rates as wages and self-employment income. The accrued interest on U.S. savings bonds is subject to federal income taxes reported on Form 1040. It is also subject to federal estate, gift and excise taxes as well as any state estate or inheritance taxes. However, the accrued interest on U.S. savings bonds is NOT subject to state or local income taxes.
WHO PAYS THE TAXES?
U.S. savings bonds can have multiple owners and this can complicate the tax situation. The following rules apply to who is responsible for any taxes due:
- ONLY ONE OWNER ON THE BOND: The owner owes the tax.
- ONE CO-OWNER BUYS THE BOND WITH ADDITIONAL CO-OWNERS NAMED ON IT: The co-owner who purchased the bond owes the tax.
- SOMEONE ELSE BUYS BOND BUT NAMES ANOTHER AS THE OWNER: The named owner owes the tax.
- CO-OWNERS BUY BOND TOGETHER WITH EACH CONTRIBUTING MONEY: The co-owners report the interest income in proportion to how much each paid for the bond.
- SPOUSES CO-OWN BOND AND LIVE IN COMMUNITY PROPERTY STATE BUT FILE SEPARATE RETURNS: Each spouse reports one-half of the interest income on their separate tax returns.
- OWNER GIVES UP BOND AND IT IS REISSUED: Previous owner owes tax on the interest earned until it was reissued.
- NEW OWNER ON REISSUED BOND: New owner owes tax on the interest earned after it was reissued.
Co-owned U.S. savings bonds can be complicated for divorcing couples. The bonds may have to be reissued in the name of one of the former spouses (although both spouses are liable for the tax on the interest up to that point). If the bond is eligible for redemption, the former couple may have agree in the judgment of divorce who receives the proceeds and who pays for the taxes due on their individual tax return.
WHAT HAPPENS WHEN THE OWNER DIES?
After the owner of the U.S. savings bond dies, the interest income will still have to be reported by the personal representative or executor of the estate. The manner in which it is reported depends on the accounting method that the decedent used:
- Accrual method – If the decedent used the accrual method and the bonds transferred to someone else because of death, the interest earned in the year of death up to the date of death must be included on the individual’s final tax return. The person who acquires or inherits the bond includes in their gross income only the interest earned after the date of death.
- Cash Method But Interest Reporting Every Year – If the decedent used the cash method but reported interest every year and the bonds transferred to someone else because of death, the interest earned in the year of death up to the date of death must be included on the individual’s final tax return. The person who acquires or inherits the bond includes in their gross income only the interest earned after the date of death.
- Cash Method But Interest Reporting Postponed – If the decedent used the cash method but postponed reporting interest to the IRS, all interest earned before death must be reported in one of two ways:
- Option 1: The surviving spouse or personal representative filing the final income tax return of the decedent can include as part of gross income all interest earned on the bonds before death. The person who acquires or inherits the bond only includes in their income the interest earned after the date of death.
- Option 2: If not included on the final tax return, the interest earned up to the date of death is income in respect of the decedent. This means that the next person who acquires or inherits the bond must report ALL interest accrued before and after death on his or her tax return or elect to postpone reporting it until the bond is redeemed or disposed of. However, this person can exclude any part of the interest reported on the estate’s Form 1041 tax return if one is filed. In the year that the interest is reported, the person can claim a deduction for any federal estate tax paid on the part of the interest included in the decedent’s estate.
WHAT IS THE EDUCATION SAVINGS BOND PROGRAM?
A taxpayer may be able to exclude from income ALL OR PART of the interest received on qualified U.S. savings bonds during the tax year that they were redeemed and the proceeds were used to pay for higher education expenses. 26 U.S.C. §135(a). This exclusion is subject to the following rules:
- Must Be Qualified U.S. Savings Bond – To be eligible, the bond must be a Series EE or Series I bond issued after December 31, 1989 to an individual who was at least 24 years old before the date of issuance. 26 U.S.C. §135(c)(1). A bond bought by a parent in the name of a child who has not reached age 24 does not qualify for the exclusion.
- Must be Qualified Higher Education Expenses – To be eligible, the proceeds of the redeemed bond must be used to pay for the tuition and fees for the enrollment or attendance of the taxpayer, the taxpayer’s spouse or the taxpayer’s qualifying dependent at a eligible educational institution which includes most public, private and non-profit universities, colleges and vocational schools that are accredited and eligible to participate in student aid programs run by the Department of Education. 26 U.S.C. §135(c)(2)(A). This does not include “expenses with respect to any course or other education involving sports, games, or hobbies other than as part of a degree program.” 26 U.S.C. §135(c)(2)(B).
- Reduce Qualified Higher Education Expenses By Certain Benefits – The taxpayer must reduce qualified higher education expenses during the tax year by all of the following tax-free benefits:
- Tax-free portions of scholarships and fellowships. 26 U.S.C. §135(d)(1)(A).
- Expenses used to figure the tax-free portion of distributions from a Coverdell ESA. 26 U.S.C. §135(d)(1)(B).
- Expenses used to figure the tax-free portion of distributions from a qualified tuition program. 26 U.S.C. §135(d)(1)(D).
- Tax-free payments received as educational assistance from veteran’s educational assistance programs, qualified tuition reductions, or employer-provided educational assistance. 26 U.S.C. §135(d)(1)(C).
- Any expense used in figuring the American Opportunity tax credit and Lifetime Learning Tax Credit. 26 U.S.C. §135(d)(2).
- Exclusion Limited To Amount Of Qualified Higher Education Expenses – If the aggregate proceeds of qualified U.S. savings bonds redeemed during the tax year exceed the qualified higher education expenses paid by the taxpayer that same year (minus deductions for any benefits such as grants or scholarships), then the excess amount is includable in the taxpayer’s gross income. 26 U.S.C. §135(b)(1).
- Income Threshold Limits – The exclusion does not apply if the taxpayer’s income is too high. 26 U.S.C. §135(b)(2). The following threshold limits apply for tax year 2021:
- Joint Return Filers: The income threshold for full exclusion is $124,800.00. Beyond that, the exclusion amount is proportionally phased out up to $154,800.00. If income exceeds $154,800.00, no exclusion can be taken.
- All Other Filers: The income threshold for full exclusion is $83,200.00. Beyond that, the exclusion amount is proportionally phased out up to $98,200.00. If income exceeds $98.200.00, no exclusion can be taken.
- No Exclusion For Married Individuals Filing Separately – Spouses must file a joint return to claim the exclusion. 26 U.S.C. §135(d)(3).
Taxpayers must use Form 8815 (Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989) to claim the U.S. savings bond education program exclusion and attach it to their Form 1040 income tax return. If the exclusion is claimed, the IRS will verify it by using bond redemption information from the Department of Treasury.
THE TAXATION OF U.S. SAVINGS BONDS CAN BE CONFUSING, BUT WE ARE HERE TO HELP!
If you have further questions about the taxation of U.S. savings bonds or need other legal assistance, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.