Tax planning for bond transactions.

Date01 December 2022
AuthorYoung, Patrick L.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Individual Tax Planning topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).

Bond interest is federally taxable when paid by a corporation, the U.S. Treasury, or certain federal government agencies, or nontaxable when paid by states, cities, or political subdivisions. Investors who purchase newly issued bonds either pay face value (i.e., purchase at par) or acquire the bond at a discount or premium, depending on market conditions. When bonds subsequently change hands, their price fluctuates based on current interest rates, the quality of the bond, its maturity, and demand.

Tax-wise strategies for US savings bonds

Electronic-form Series EE savings bonds are issued at face value. Interest on Series EE bonds accrues and is paid at the earlier of their redemption or maturity. For each year prior to maturity, the bond's redemption value increases. This annual increase in value represents the interest accrual for each year. Cash-basis taxpayers generally report the interest earned on Series EE bonds in the year the bonds are redeemed or mature, whichever comes first. Series EE bonds mature after 30 years.

Series I U.S. savings bonds combine the features of deferring taxes on the interest until maturity with inflation-protected growth. Series I bonds are issued at face value and pay a fixed interest rate plus a semiannual inflation-adjusted rate. Interest is added to the bond monthly and paid when the bond is redeemed. As they do with Series EE bonds, cash-basis individuals report interest on Series I bonds in the year of maturity (or in the year redeemed, if earlier). Taxpayers can use their tax refund to purchase Series I bonds.

Planning tip: Savings bonds can be a sound investment for children subject to the kiddie tax. While income from savings bonds is being deferred, no kiddie tax liability is incurred. After graduation, the child can redeem the bonds or elect to accrue the interest to date. In either case, the child will presumably pay taxes at a rate lower than the parents. Alternatively, the child can continue to defer the savings bond income and the tax liability thereon after graduation.

Election to accrue interest income

Taxpayers can elect to report interest on the accrual method (i.e., as earned) for Series EE and Series I bonds (Secs. 454(a) and (c)). If made, the election applies to all such bonds owned in the year of election and to any subsequently acquired. Furthermore, in the year of election, the taxpayer must report all income accrued on the bonds from the date of acquisition. If the taxpayer holds Series HH...

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