Tax planning for bond transactions

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 bonds received in exchange for Series EE bonds, the election also applies to the accrued Series EE interest at the time of the exchange (if such interest was not reported at the time of the exchange) (Regs. Sec. 1.454-1(a)(1); IRS Letter Ruling 8217231)).

The election to convert to the accrual method for U.S. savings bond interest should be considered for a taxpayer when any of the following occurs:

• Additional current income may go untaxed (e.g., the taxpayer’s income is below the filing limit) — this includes bonds owned by children who are not subject to the kiddie tax;
• Additional current income would be taxed at a lower rate than income in the year of the bond’s maturity (after considering the time value of money);
• The tax rate is relatively low for the final return of a deceased taxpayer in relation to the tax rate of the estate or beneficiaries;
• A carryforward item (deduction or credit) is expiring or otherwise could be used to offset the additional income;
• Itemized deductions are of little or no benefit because of a low level of taxable income or the standard deduction exceeds the itemized deductions; or
• The accelerated income may be offset by a deduction for investment interest that would otherwise be deferred under Sec. 163(d).

This election represents one of the few opportunities to manipulate taxable income as late as when the tax return is being prepared.

Caution: The taxpayer should consider the impact of the accrued and recognized income on the taxability of Social Security benefits. If the election is not made, all income on the bond is taxable at maturity, thus affecting the taxation of Social Security benefits only in the year of the bond’s maturity. If the election is made, the income may affect the taxability of Social Security benefits in multiple years. However, spreading the income may create less of an impact than including all of the accrued interest in the year the bond matures.

The election to accrue interest on U.S. savings bonds is made by attaching an election statement to the taxpayer’s return for the year it is effective (Regs. Sec. 1.454-1(a)). It can be revoked only with IRS consent, but the IRS provides taxpayers with an expeditious method of revoking the election, thereby allowing them to return to the cash-basis method for reporting the interest income. Revoking the election may be appropriate when income recognized under the accrual method is subject to tax or taxed at an increased rate.

If a U.S. savings bond is transferred during the owner’s lifetime, the transferor generally must recognize any income that has been accrued but not yet reported. Nevertheless, gifting a bond may be beneficial if substantial income is yet to be earned on the bond and the donee is in a lower tax bracket than the donor. The donor could structure the transfers as annual gifts qualifying for the annual gift tax exclusion under Sec. 2503(b). The value of the gift would be the sum of the bonds’ redemption values (according to government tables), which include accrued interest. The donor must include in income the increment in value (accrued interest) as of the date of the transfers. Any subsequent earnings on the bonds are taxed to the donee.

A Series EE (and, presumably, a Series I) bond can be transferred to a revocable (living) trust without triggering the deferred income (Rev. Rul. 58-2; IRS Letter Ruling 9009053). A Series HH bond can also be transferred to a revocable trust without triggering the deferred Series E and EE interest income.

U.S. savings bonds are subject to state inheritance, gift, and excise taxes. They are not, however, subject to the income taxes of states, U.S. possessions, or local taxing authorities. Taxpayers living in high-tax states may achieve tax savings by investing in U.S. bonds, since the interest is not taxable by states. However, such taxpayers must own the bonds directly, not through a qualified plan or individual retirement account (IRA), to achieve state income tax savings. Most states tax IRA and qualified plan distributions (to some extent) regardless of the nature of the assets held in the plan or IRA.

Planning tip: Tax savings can also be realized by using Series EE U.S. savings bonds to pay for a child’s education expenses. All or a portion of interest on Series EE U.S. savings bonds issued after Dec. 31, 1989, may be excluded from income if bond proceeds are used to pay qualified higher education expenses at eligible educational institutions (Sec. 135). However, from an investment strategy standpoint, the returns from other investments may exceed the relatively low yields on savings bonds, making other investments preferable despite the exclusion of savings bond interest.

Tax aspects of inflation-indexed bonds

Treasury Inflation-Protected Securities (TIPS) are five-year, 10-year, and 30-year marketable Treasury securities issued in electronic form and indexed for inflation. They are sold in multiples of $100 and provide investors with a guaranteed hedge against inflation.

Interest on TIPS is paid semiannually at a fixed interest rate. Also, the bond’s principal for computing interest is adjusted semiannually for economic inflation or deflation (based on a government consumer price index). If the bond’s principal increases during its term because of inflation adjustments, the increase is paid at maturity. If deflation causes the bond’s adjusted principal at maturity to be less than its face amount, Treasury will pay the face amount.

How bondholders are taxed

Each year, holders of TIPS are taxed on the interest they receive plus any increase in the principal resulting from the inflation adjustment. If the bond’s principal decreases because of deflation, the holder can offset the interest income received during the year by the decrease. If the decrease exceeds current-year income from the bond, a loss can be claimed to the extent the holder has previously recognized income from the bond; any excess is carried over to offset future income.

Taxing the inflation adjustment as it occurs rather than when paid (at maturity) causes the holder to prepay the tax on funds that will be received later. This acceleration of the tax liability on the inflation adjustment to the bond’s principal is perhaps the most significant drawback to holding these bonds.

Holders of TIPS will use one of two methods to account for the bond’s stated interest and original issue discount (OID): (1) the coupon bond method or (2) the discount bond method (Notice 96-51 and Regs. Secs. 1.1275-7(d) and (e)). The coupon bond method applies when (1) a de minimis difference exists between the debt instrument’s issue price and its principal amount at issuance and (2) all stated interest is payable in cash at least annually (Regs. Sec. 1.1275-7(d)(2)). This method will apply to TIPS that are not stripped into principal and interest components.

For TIPS issued after April 7, 2011, the coupon bond method must be used for TIPS issued with more than a de minimis amount of premium (Regs. Sec. 1.1275-7(d); Notice 2011-21)).

The discount bond method is used if the bond does not qualify for the coupon bond method (e.g., the bond is issued at a discount). The discount method essentially requires the taxpayer to accrue OID using the constant-yield method under Regs. Sec. 1.1272-1(b)(1).

A purchaser of an inflation-indexed bond in the secondary market uses the bond’s adjusted issue price (i.e., inflation-adjusted principal amount) on the date of acquisition for purposes of determining bond premium or market discount (Regs. Sec. 1.1275-7(f)(3)).

Tax effects of increases to the bond’s principal

As previously stated, inflationary increases to the bond’s principal are taxed each year even though the bondholder does not receive payment for such increases until the bond matures. This creates phantom income to the holder because tax is being paid on income that is not currently received. This greatly decreases the cash flow a holder realizes during the term of the note.

If a TIPS is analyzed on a cash-flow basis, the tax on the inflationary increases to principal results in an exorbitant effective tax rate until the year of maturity.

As inflation increases, the significance of reporting phantom income from the increases in the bond’s principal becomes more pronounced. Periods of high inflation can actually result in current tax liabilities that exceed the cash income the bondholder receives during the year.

Investors in TIPS may be surprised by each year’s tax liability relative to the cash received. In this regard, TIPS with inflationary growth have similar characteristics to OID bonds, i.e., tax on accrued but deferred cash income. Investors unaccustomed to the taxation of OID debt instruments need to be warned of the tax implications of TIPS before investing.

Because inflationary adjustments to indexed bonds are taxed currently rather than when the cash is received at maturity, the tax ramifications of TIPS cancel out some of the inflationary protection they are designed to provide. Thus, these securities may be more suitable for retirement plans such as IRAs or 401(k) plans, where tax is deferred until the taxpayer makes withdrawals from the plan. They may also be appropriate fixed-income investments for investors with an investment portfolio that includes stocks, particularly when rising interest rates due to inflation are a concern. Increases in interest rates can have detrimental effects on both stock and bond investments, so these bonds may be less volatile than others because of the inflation protection.

Contributor

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. 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).