Monday, September 29, 2008


Recently a childhood friend, and long-time client, asked me about the tax treatment of savings bond interest on bonds that were owned by his recently deceased mother. His name was also on the bonds. He had not cashed the bonds yet, and wanted to know if he had to or if he could continue to hold on to the bonds.

FYI my friend provided more than half of his mother’s support and had been claiming her as a dependent on his 1040s. As his mother lived with him in his condo he filed as Head of Household. She filed a tax return each year to report a small pension and some minor interest on bank accounts, totaling slightly more than the standard deduction amount for a dependent, and used medical expenses to bring her net taxable income to “0”.

As a preface, I expect we all know that the annual interest earned on US Series E or I Savings Bonds is not currently taxed, but “accrue” and are taxed in full when you cash in the bond – unless you elect to report the accrued interest each year.

The optional method is often recommended for young children with no taxable income – to reduce the overall tax liability on the accrued bond interest. In the year or birth many children are often given savings bonds by relatives and family friends. If the parents file a tax return (with “0” tax liability) for the child’s first year reporting that year’s bond interest, and indicating on Schedule B that they are reporting the accrued interest on US Savings Bonds on an annual basis, then another tax return does not have to be filed until such time as the child has taxable income. In the early years when the child has no tax liability federal income tax is avoided altogether on the interest earnings.

The only possible downside to using the optional method for children is that it requires the parents to keep a good ongoing record of the accrued interest for each year on each bond. This becomes more involved if the child receives additional bonds each year as birthday or Christmas gifts. The amount of annual interest accrued on a bond can be determined on the Savings Bonds website.

We all also should know that US Savings Bond interest is exempt from state income taxes.

In the case of my friend, his mother had not been reporting bond interest annually – and the accrued interest added up to a very substantial amount.

To be honest the only thing I was sure about concerning interest on bonds of a deceased taxpayer was that the surviving spouse or executor can elect to include all of the interest earned on the bonds before the date of death on the deceased’s final 1040, even if the bonds were not cashed in. In this case the person who acquires the bonds after death only has to report interest earned after the date of death.

Other than that I was a bit unsure, so I did some research and found the following -

If one of two people named on a bond is deceased, the surviving person is automatically the owner as if that survivor had been the sole owner from the time the bond was issued.

If you are named in a bond's registration with someone else who is now deceased, you can:

* Do nothing with the bond
{no tax consequence, unless you report the accrued interest up to date of death on the deceased’s final 1040 – rdf};

* Redeem the bond by presenting it with adequate identification at a financial institution that pays savings bonds
{and pay the tax – rdf}; or,

* Get the bond reissued (re-registered) in your name alone or with some other living person as long as the bond is still earning interest and is not approaching final maturity
{again no tax consequence unless interest reported on deceased’s 1040 - rdf}.

To have a savings bond reissued in this situation, you'll need to send a certified copy of the deceased person's death certificate with the bonds and a reissue request
PD F 4000 to a Treasury Retail Securities Site.

If the transferred bonds were owned by a decedent who had used the cash method and had not chosen to report the interest each year, and who had bought the bonds entirely with his or her own funds, all interest earned before death must be reported in one of the following ways.

(1) The surviving spouse or personal representative (executor, administrator, etc.) who files the final income tax return of the decedent can choose to include on that return all of the interest earned on the bonds before the decedent's death. The person who acquires the bonds then includes in income only interest earned after the date of death.

(2) If the choice in (1) is not made, the interest earned up to the date of death is income in respect of the decedent. It should not be included in the decedent's final return. All of the interest earned both before and after the decedent's death (except any part reported by the estate on its income tax return) is income to the person who acquires the bonds. If that person uses the cash method and does not choose to report the interest each year, he or she can postpone reporting it until the year the bonds are cashed or disposed of or the year they mature, whichever is earlier. In the year that person reports the interest, he or she can claim a deduction for any federal estate tax that was paid on the part of the interest included in the decedent's estate.

Example 1:

Your uncle, a cash method taxpayer, died and left you a $1,000 series EE bond. He had bought the bond for $500 and had not chosen to report the interest each year. At the date of death, interest of $200 had accrued on the bond and its value of $700 was included in your uncle's estate. Your uncle's executor chose not to include the $200 accrued interest in your uncle's final income tax return. The $200 is income in respect of the decedent.

You are a cash method taxpayer and do not choose to report the interest each year as it is earned. If you cash the bond when it reaches maturity value of $1,000, you report $500 interest income—the difference between maturity value of $1,000 and the original cost of $500. For that year, you can deduct (as a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit) any federal estate tax paid because the $200 interest was included in your uncle's estate

All of the above information is taken from here and here.

An article in THE CPA JOURNAL of the NY State Society of CPAs provides the following example-
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.)

So what about my friend? He has decided that we will not report the accrued interest up till the date of death on his mother’s final tax return, as this would generate a substantial current tax liability and make him unable to claim her as a dependent or file as Head of Household for 2008. As the bonds have a while to go before they mature, my friend will hold on to them for now and cash them in a few each year beginning some time after he has retired, thus spreading out the tax liability.

Any questions?


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