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Saturday, May 4, 2024
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Case Studies |
Seeing Double with U.S. Savings Bonds, Part 1
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Case:
Bill Bonds is a retired construction worker. While still an avid home improvement enthusiast, Bill hung up his hard hat after 40 years in the business. During his working years, Bill invested in several different places, such as an IRA and a deferred commercial annuity. Bill also purchased U.S. savings bonds.
Specifically, Bill bought U.S. Series EE savings bonds 20 years ago for $5,000. The face value of the bonds was $10,000. Bill's bonds have reached the original maturity date - 20 years from the bond's issue date. He knows he has several options with respect to the savings bonds. However, Bill does not know what he should do next. He can redeem the savings bonds, continue to hold them or convert them. Bill also wants to discuss the charitable giving options, if any, with respect to the savings bonds.
Question:
What options does Bill have for his bonds? What are the tax consequences of each option?
Solution:
U.S. savings bonds are government backed bonds issued by the Department of Treasury. Series EE (formerly Series E) are a very popular type of savings bonds. They are purchased at a discount and are guaranteed a certain value upon "original maturity," which is 20 years after the issue date. The increase in value from the purchase price to the original maturity price reflects accumulated interest income.
Fortunately, this accumulated interest income goes untaxed each and every year. It is not subject to federal, state or local income taxes. However, a taxpayer may elect to realize the interest income each year. See Sec. 454(a). Because of the tax liability that results from realizing savings bond interest income each year this is a rare decision.
"Option #1 - Redeeming the savings bonds."
In the event Bill wants the cash value of his savings bonds immediately, he simply can redeem the Series EE savings bonds. The lifetime redemption of U.S. savings bonds is relatively straightforward. There are literally thousands of financial institutions authorized to redeem Series EE savings bonds. Bill need only provide proper identification to one of these financial institutions.
The most common method of redemption is to "cash in" savings bonds at a local bank. This is the simplest and most cost-effective method. If this were Bill's selected option, he would make a trip to his local bank and redeem the $10,000 of savings bonds quickly and easily.
Upon redemption, Bill would receive $10,000. (In some instances, the bank may withhold a percentage of the cash value, e.g. 20%.) As a result of the redemption, Bill would also have $5,000 of taxable interest income. The $5,000 of taxable income ($10,000 - $5,000) represents the untaxed interest income that accumulated over the past 20 years.
It is important to note that the $5,000 is not capital gain income, but interest income subject to ordinary income tax rates. Therefore, assuming that Bill is in the 25% tax bracket, he would owe income taxes of $1,250 (5,000 x .25). When the dust settles, Bill would net $8,750 from the redemption of his savings bonds (10,000 - 1,250).
Before proceeding with the redemption option, Bill wants to investigate further. In part 2, Bill will review the pros and cons of holding the Series EE savings bonds beyond the original maturity date.
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