U.S. savings bonds for investment purposes. (Personal Financial Planning)by Gordon, Sheldon
2. They permit, with certain restrictions, a tax-free education fund for children and adults.
3. They are direct obligations of the U.S. government, backed by its full faith and credit.
4. The interest income is not subject to state or city income taxes.
5. The interest paid is the greater of a variable market-based rate or the minimum rate.
6. They can be purchased and redeemed without commission.
7. They pay interest rates that are competitive with certificate of deposit and money market accounts, if held for more than five years.
8. They may be registered in the name of two co-owners or one owner and one beneficiary which will facilitate transfer at death without the delay of probate.
Two types of U.S. Savings Bonds are presently available, Series EE and Series HH bonds.
Series EE Bonds
The Series EE bond is an appreciation-type security that is issued for an original maturity of 12 years and is available in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. The purchase price is one half the denomination, for example, a $100 bond costs $50. They may be purchased at most commercial banks, many savings institutions, and through the payroll savings plan offered by thousands of employers. (The $50 and $75 denominations are not available to payroll savers.)
Series EE bonds issued on or after November 1, 1982, and held at least five years, earn interest at a variable, market-based rate, or a minimum rate, whichever is greater. The minimum guaranteed rate on bonds issued between November 1, 1982, and October 31, 1986, is 7.5%. The current minimum guaranteed rate is 6%. The market-based rate is equal to 85% of the average yield on five-year Treasury marketable securities during the time the bond is held, compounded semi-annually. Interim market-based rates, useful for tracking the market-based average applying to a bond, are announced each May 1 and November 1. The market-based rate for the period May 1, 1991, to October 31, 1991, was 6.57%. Market-based rates vary according to the issue dates of individual bonds, but the minimum guaranteed rate can only be changed by the President.
An EE bond reaches face value no later than the end of the term for which it was issued and is based on the minimum rate. If the market- based rate applying to the bond is higher than the minimum, it reaches face value sooner. In either case, the bond continues to earn interest for its full term. EE bonds are guaranteed to earn interest for 30 years from issue date.
If redeemed before five years, EE bonds earn interest on a fixed, graduated scale, beginning at 4.16% for bonds held six months rising gradually to the minimum rate at five years. Interim yields are published in Treasury Department Circular, Public Debt Series No. 1-80.
Series HH Bonds
Series HH bonds are current-income securities in denominations of $500, $1,000, $5,000, and $10,000. They are issued only in exchange for Series E (no longer issued), EE, and Savings Notes, with redemptions at face value. It has an original maturity of 10 years, which is automatically extended for another 10-year term. In addition, the proceeds of a matured H bond may be re-invested in an HH bond, but any tax deferral applying to the H bond principal expires at the the time the H bond matures. HH bonds are redeemed at face value. Interest (currently 6%) is paid semi-annually by direct deposit electronic fund transfer from the Treasury Department.
HH Bond Exchange Privilege
Unless owners have a need for current income, or their older E bonds and Savings Notes are reaching final maturity, they should consider the matter carefully before making an exchange for HH bonds. They may find interest earned on the HH bonds less than on the securities exchanged.
HH bonds received in an exchange are not subject to an annual limitation on purchase. If a cash adjustment is received in an exchange, the amount received is interest income to the extent that it represents unreported interest earned on the securities exchanged. Form PD F 3243 is used to apply for an exchange. #Sec. 352.7 of DCPD 2-80 (31 CFR, Part 352 has the full details.
Tax Deferral Privileges
When EE bonds are purchased, a cash basis taxpayer is permitted to either report interest each year as it accrues or defer the reporting of interest until the year in which the EE bonds are cashed, disposed of, or reach financial maturity, whichever comes first. Because these bonds may be held for up to 30 years and then converted into HH bonds without the need to report interest earned on the EE bonds, the taxpayer may defer payment of income tax on the EE bonds for up to 50 years. Upon conversion, the original owner of the EE bonds must remain the owner or the first-named co-owner of the HH bonds and is required to include in gross income all of the interest on the HH bonds.
A change in the registration of a U.S. Savings Bond that does not change its ownership will not result in a shifting of income tax liability. Thus, if the original owner of a bond has it reissued in his or her own name and another person as co-owners, it is not considered a disposition that requires the owner to include in his or her gross income the accrued and previously unreported interest on the bond. (Rev. Rul. 64-302, 1964-2 C.B. 170; Rev. Rul. 58-2, 1958-1 C.B. 236.)
Similarly, if a Savings Bond is registered in the name of the person who furnished the funds for its purchase and in the name of another person as co-owners, and the bond is reissued to eliminate the other person's name, no disposition or taxable event has occurred. (Rev. Rul. 68-61, 1968-1 C.B. 346.)
If, however, the owner of a bond changes the registration so that he or she is no longer the sole or co-owner, the change in registration is considered a disposition of the bond, and previously accrued unreported interest must be reported. When a taxable disposition occurs in a re- issue transaction, the reporting and backup withholding provisions of the IRC apply even though no interest payment is received by the former owner.
If a cash basis taxpayer is reporting interest increments as income each year, a change back to deferral is automatically permitted by attaching Form 3115, "Change of Method of Accounting," to a timely filed income tax return. A statement agreeing to report all untaxed income upon redemption or disposition must also be attached (Rev. Proc. 89-46).
The Education Tax Exclusion
TAMRA 88 authorized a special tax exclusion for the interest income of Savings Bonds redeemed in a year with offsetting post-secondary educational expenses. To qualify for the interest exclusion, the bonds must be issued after December 31, 1989, to individuals who are at least 24 years old. If the bonds are intended to benefit dependent children, they must be issued in either one parent's name or both parents' names. The bonds cannot be issued in the name of a child, although a child may be the registered beneficiary. The bonds must be redeemed in a year the bond owner pays qualified educational expenses, which are tuition and fees, to an eligible educational institution. Room, board, and books are not qualified expenses. Eligible educational institutions include colleges, universities, technical institutes, and vocational schools.
The interest on qualifying bonds will be fully exempt from federal income tax only if the qualifying tuition and fees paid during the year are equal to or more than the redemption proceeds (principal and interest) of qualified bonds, regardless of how the qualifying bond proceeds are actually used. If tuition and fees are less than the value of the bonds cashed, the exemption is proportional to the percentage of the value that was used for tuition and fees. For example, if $10,000 worth of bonds are redeemed during the year, but tuition and fees total only $8,000, 80% of interest income is exempt from federal income tax.
Income limits apply to the year of redemption of the bonds. In 1991, the limit for single taxpayers is $41,950 modified adjusted gross income, and for joint returns, $62,900 modified adjusted gross income. Married taxpayers filing separately are not eligible for the exclusion. There is a partial exclusion for single taxpayers with incomes between $41,950 and $57,700, and for joint returns reporting incomes between $62,900 and $94,350. All income levels are adjusted for inflation for years after 1991.
The IRS has issued Form 8818 to assist taxpayers in keeping records of transactions that may qualify for the interest exclusion. To obtain copies of the form, and to get additional information on the exclusion, taxpayers should call or write their district IRS office.
Special Rules that Apply When Bonds are Transferred
Transfer of Bond Through Death of Owner. An individual buys an EE bond, listing a nephew as co-owner (or beneficiary). The purchaser dies after several years; the nephew becomes sole and absolute owner of the bond.
The death of the original owner does not result in a taxable event for federal income tax purposes. The income tax liability on the accumulated interest would pass, along with the bond, to the nephew, and would remain his along with liability on additional accruals. (Rev. Rul. 64-104, 1964-1 C.B. 223.) However, if the person filing the final income tax return of the decedent elects to include all interest earned on all bonds owned by the decedent to the date of the decedent's death, the nephew's tax liability would extend only to the interest accruing from that date. (Rev. Rul. 68-145, 1968-1 C.B. 203.)
The tax liability would be the same if the purchaser in this example had bought the bond in his name alone, and the nephew had received the bond as a specific legacy and had it reissued in his name. However, if the bond were received not as a specific legacy, but as a settlement of a specific dollar legacy, then the legal representative of the estate for federal income tax purposes would report the accrued interest up to the time of distribution, and the nephew would assume income tax liability for the interest accruing after re-issuance.
Reissues from Parent to Child. A parent who has bought and held an E or EE bond for several years decides to make a gift of it to his or her child. The bond is reissued in the child's name alone, or with the parent or someone else as a beneficiary. Such a reissue is a taxable event. Any accrued interest previously unreported would have to be included in the gross income of the parent for the taxable year for which the reissue took place. The interest accruing thereafter would be the liability of the child for income tax purposes. (Rev. Rul. 54-327, 1954-2 C.B. 50.)
Transfer of a Bond to a Trust. Upon the re-issuance of bonds to a trust, the owner must include in gross income the accumulated interest on the bonds, including any tax-deferred increment noted on the H or HH bonds not already reported unless, under the grantor trust provisions of the IRC, the owner of the bond is treated as the owner of the portion of the trust represented by the tax-deferred accumulated interest on the reissued bonds. If the bond owner is treated as the owner of that portion, the accumulated interest continues to be income of the bond owner rather than of the trust and, therefore, the bond owner can continue to defer reporting the interest earned each year. The bond owner must include the total accumulated interest in gross income when the bonds are disposed of or finally mature, whichever is earlier.
Financial Planners Should Not Hesitate to Recommend
The rate of interest paid on U.S. Savings Bonds compares favorably with interest paid on other risk-free investments. As noted earlier, the current market-based interest rate is 6.57% until October 31, 1991. This minimum interest rate is guaranteed if the bonds are held at least five years. When this rate is adjusted for the fact that the bonds are exempt from state and city taxes, and completely tax-free if the taxpayer is eligible for the education or the minor child exemption, the actual effective rate is generally from .5% to 3% higher than the market-based rate. If one considers the safety factor, the tax deferral feature, the potential use as a tax-free education fund, and the competitive variable interest rate, it becomes apparent that U.S. Savings Bonds require close scrutiny by the financial planner.
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