Tax planning opportunities for U.S. Series E and EE savings bonds.

• Author: Bakale, Anthony

Many taxpayers own U.S. Series E and EE savings bonds. These bonds, issued at a discount, can be redeemed for fixed amounts that increase at stated intervals. The difference between the purchase price and the amount received at redemption is interest income, when the bonds are redeemed. Under Sec. 454(a), taxpayers can elect an accrual basis for Series E and EE savings bonds. Taxpayers can elect to recognize the annual increase in the bond's redemption value as interest income as it accrues, rather than reporting all of the income in the year in which they redeem the bond. Two situations exist in which taxpayers should consider electing to recognize the annual increase as interest income.

Accrual-Basis Election

The first situation involves untaxed accrued interest on Series E and EE savings bonds owned by a deceased taxpayer. A generation of taxpayers born prior to World War II invested heavily in savings bonds as patriotic investments. As this generation passes, situations in which a tax election on these bonds can benefit these taxpayers' estates increase. At first glance, it appears that the untaxed accrued interest would be income to the estate on a fiduciary income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts) when the estate redeems the bonds. However, under Rev. Rul. 68-145, the personal representative (or such other responsible party) can elect (under Sec. 454(a)) to report the untaxed accrued interest when a decedent dies as interest income on the decedent's final individual income tax return. The personal representative must elect this treatment. Once made, the election is not revocable without IRS consent. If the estate continues to hold the bonds, it should recognize the annual increase in their value as accrued interest income on Form 1041. This treatment should continue until the estate redeems the bonds or they are transferred to a beneficiary. If the bonds were transferred, the beneficiary would not be bound by any election made by the estate and could elect a cash or accrual basis for the bonds.

If the personal representative elects to include the untaxed accrued interest on the decedent's final individual return, the estate could save considerable taxes, as individual tax brackets are significantly larger than the estate and trust tax brackets. In addition, even if the decedent lived for only a portion of the year, the decedent's personal exemption and standard deduction (if applicable) would not be...