Income Tax Planning for Savings Bonds

I can’t believe it was almost three years ago that I researched Estate Planning and Savings Bonds, wow time flies!  Notwithstanding, there are various tax strategies when dealing with your Savings bonds.  The first has to do when you should “choose” to pay tax on the interest gained and the second has to do with a possible way to eliminate the tax totally.

When Should You Declare Your Government Savings Bond Income?

While United States Saving Bonds are exempt from State income tax they are taxed at the federal level.  However, the Federal Government provides for two ways to actually report this income (From TreasuryDirect.gov)

1. Cash Basis Reporting-federal tax is deferred until the year of final maturity, redemption, or other taxable disposition, whichever is earlier.
2. Accrual Basis Reporting-you report interest annually each year as it accrues. Once you start, you must continue to report interest earned annually for all savings bonds and notes you own and any you may acquire. This may be advantageous for EE/E Bonds in a child’s name.

Why Choose One Method Over the Other?

Like almost every single thing in personal finance this is going to be a personal decision based on your specific circumstances, but the answer should be pretty obvious.

• If you are currently in a higher tax bracket now there is no reason to increase that tax burden (especially if you don’t need the money or can’t cash it in due to penalties or a lower payout)
• If you are in a lower tax bracket then cashing in the bonds may minimally increase your tax burden (or not at all if you are below a certain income amount).

Completely Eliminate Taxable Interest on US Savings Bonds

There is actually a strategy condoned and written about by the IRS that can avoid your taxable interest on United States Savings Bonds.  In IRS Publication 970 (updated in 2010) Chapter 10 the IRS provides the guidelines for those who can “Cash in Bonds Tax Free”

You may be able to cash in qualified U.S. savings bonds without having to include in your income some or all of the interest earned on the bonds if you meet the following conditions.

• You pay qualified education expenses for yourself, your spouse, or a dependent for whom you claim an exemption on your return.
• Your modified adjusted gross income (MAGI) is less than $85,100 ($135,100 if married filing jointly or qualifying widow(er)).
• Your filing status is not married filing separately.

Qualified U.S. savings bonds.   A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners).

The owner must be at least 24 years old before the bond’s issue date. The issue date is printed on the front of the savings bond.

Couple items to think about:

• Qualified Eduction Expense for the purpose of income tax planning for savings bonds doesn’t only include payments actually made to the college it could include contributions to a Coverdell Eduction Savings Account.  Think about that one!
• Your Modified Adjusted Gross Income needs to be considered it isn’t just your salary.
• Tax Savings Benefits will be offset by “adjusted qualified education expenses”

The IRS even provides us with an example in Publication 790:

In February 2010, Mark and Joan Washington, a married couple, cashed a qualified series EE U.S. savings bond. They received proceeds of $9,000, representing principal of $6,000 and interest of $3,000. In 2010, they paid $7,650 of their daughter’s college tuition. They are not claiming an American opportunity or lifetime learning credit for those expenses, and their daughter does not have any tax-free educational assistance. Their MAGI for 2010 was $80,000.

$3,000 interest

×

$7,650 AQEE $9,000 proceeds

=

$2,550 tax-free interest

They can exclude $2,550 of interest in 2010. They must pay tax on the remaining $450 ($3,000 ? $2,550) interest.

Have you ever used this strategy to save on taxes? Did you ever fail to use this strategy?

Remember I am not your CPA or Tax Attorney – PLEASE WORK WITH YOUR PROFESSIONAL BEFORE IMPLEMENTING ANYTHING YOU READ ON THE INTERNET!