I and EE might sound like gibberish, but they are official names…for a savings bond. Buy them or receive them as gifts, you should know that these are unusual investments that have uncommon tax options. Some of these tax considerations can be leveraged using tax avoiding or shifting strategies.
That is correct! I said avoid taxes, which is very different than evade taxes. Avoiding taxes occurs when you legally take advantage of tax rules in order to lower your tax liability. Evade taxes is the illegal process of subverting the law. Tax shifting is when you defer or shift taxes to other entities or tax periods.
Ways to Record Interest Income for a Savings Bond
Federal savings bonds are only taxable at the federal level and are exempt from state and local income taxes. However, the federal government has two ways to record the interest income. You can either defer your interest income until you redeem the bond or record the interest that has accrued each year. If you have multiple bonds, you must be consistent in how you report the interest income. For example, if you are deferring interest, all of your bonds must be deferred.
This flexibility in recording interest income and other benefits, soon to be mentioned, allow two methods for avoiding interest and one option for shifting the liability.
Who Pays the Interest?
The rule that determines who is liable to pay interest on a savings bond depends on who is listed as the owner and who made the bond purchase. If there is only one listed owner on the bond, the owner is responsible to pay the taxes. If there is more than one owner, it is the responsibility of owner that paid for the bond.
Avoid Taxes When Your Children are Young
In my post about my 10 financial goals for the current year, I mentioned that my children had savings bonds that they received as birthday gifts. Provided that my children are listed as sole owners on the bonds, they can avoid paying taxes on the interest until they start earning income from a job.
If your children are listed as the sole owner of the savings bond, then they should record the accrued interest annually on their taxes. Your child will not have any tax liability so long as the interest income from the bonds does not exceed your child’s personal deduction (roughly $3,700). If your children are very young, this tax strategy will save them a considerable amount of tax liability over time.
Avoid Taxes When You Use Savings Bonds for Education
My Journey to Millions does an excellent job explaining how this strategy works:
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.
A couple items to think about:
- Qualified Education 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 Education 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”
Shift Taxes Away from the Savings Bond Beneficiary
There is one other strategy worth considering. As I explained earlier, the bond owner that purchased the bond is liable to pay the tax liability for the interest. This rule allows for the potential to shift who is liable to pay the taxes.
For example, if you wanted to shift the tax obligation from a child to yourself, you would purchase the bond listing both you and your child as co-owners. In this scenario, you’d be liable to pay the taxes, but your child has an equal right to redeem the bond when they want.
Take advantage of these tax rules, especially if you have young children or grandchildren. They will thank you later.