Reporting Interest Income From Series E, EE and I Savings Bonds

IRC Section 454(a) provides an election to switch reporting methods on interest income from certain Savings Bonds — advantageous for individuals in higher tax bracket. Read more.

February 7, 2008
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Savings bonds are an excellent investment from a tax standpoint, because they provide investors with (they really need to specify who gets flexibility)  flexibility of when to report interest income.

IRC Section 454 establishes the rules for reporting interest income for Series E, EE and I savings bonds. In general, savings bond interest is reported at the time the bonds are redeemed or they reach final maturity. Alternatively, individuals can elect to report interest each year as it accrues.

Regardless of the election for federal purposes, this interest income is exempt from state income taxes.

Tax Planning — Deferring Reporting of Interest Income

Most individuals defer reporting interest earned on savings bonds because there is no Form 1099 issued, as for most interest income, and there are no quarterly statements. For those who choose to defer reporting interest, there is a strong likelihood that many may redeem bonds in a year when they have lesser income. This could occur when an individual retires, or loses a job. He or she will have a financial need to redeem the bonds, and most likely will be in a lower tax bracket. This is important because the accrued interest earned up until redemption could represent many years of accrual. If a taxpayer was in a higher tax bracket in the year that savings bonds were redeemed, the tax burden could be substantial.

Tax Planning — Reporting Each Year’s Accrued Interest

Sometimes, reporting each year’s accrued interest is the preferred strategy. For instance, children who receive savings bonds as gifts should consider reporting each year’s accrued interest on their tax returns. If the total of their accrued interest plus other unearned income is under $1,700, the interest from the savings bonds will be taxed at a rate not over 10 percent. If a child will have over $1,700 of unearned income, the kiddie tax will apply. Any unearned income in excess of $1,700 will be taxed at the parent’s top rate. Therefore, if a child will have less than $1,700 of unearned income taking into account interest from savings bonds, the interest should be reported annually. In the year that he or she redeems the bonds, the only interest to be reported will be the interest that accrued in the year of the redemption. The child will be an adult in a higher tax bracket. Since this election requires only that the current year’s interest be reported, rather than all of the accrued interest over the length of time the bond was held, the tax under this election will be much less than if all the accrued interest over the entire holding period was required to be reported in the year of redemption.

Election to Switch Reporting Methods

IRC Section 454(a) provides that an individual who has elected to defer reporting interest may elect to report all of the accrued interest on bonds through the end of the year in which the election to switch was made. Then, in succeeding years, the individual must report the accrued interest for each year. If this election is made, it applies to all savings bonds. An individual who owns many savings bonds cannot “pick-and-choose” which bonds the election applies to.

This election is advantageous for individuals who own savings bonds and will be in a much higher income tax bracket in the year that they are redeemed.

The election is also advantageous when an individual has excess investment interest expense. IRC Section 163(d) limits the deduction for investment interest expense to the amount of an individual’s investment interest income. Although any excess amount can be carried forward indefinitely, making this election has two advantages. First, the accrued savings bond interest reported in the year of the switch is offset by the investment interest expense that would have been carried forward. Second, in the year the bonds are redeemed, only the amount of interest earned in the year of the redemption is reported.

Electing to Report Interest on Final Return

A personal representative of an estate can elect to report all the accrued interest up to the date of death on the decedent’s final income tax return. Then, when an heir redeems the bonds, the only interest to report will be the interest that has accrued from the date of the decedent’s death [Rev Rul 68-145, 1968-1 CB 203].

LexisNexis Tax Center subscribers: See LexisNexis Tax Advisor — Federal Code for in-depth coverage of IRC 454 on Tax Center.

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