Tax Tips - Reporting Interest on U.S. Savings Bonds

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First, a U.S. Savings Bond is a bond instrument issued by the U.S. Government and can be purchased on the U.S. Treasury website. They are purchased at a 50% discount on the face value and at maturity can be surrendered at their face value. The difference between the purchase price and the maturity proceeds (face value) is considered the interest earned on the bond. These bonds have a 30 year bond maturity term, so in each year, one-thirtieth of the difference is deemed to be earned interest.

Virtually all of us are cash basis taxpayers, and as such we would normally recognize interest on the savings bonds only at maturity or redemption of the bond, which is the default method. The bank or the U.S. Treasury would issue the 1099-INT for the amount of interest and we simply pay income tax on that interest amount.

An alternative method allowed would be to pay tax on the interest earned a prorate basis for each year the bond is owned. This method is referred to as the accrual method. By way of example, if you purchase a $1,000 bond for $500, the prorated interest earned each year would be 1/30th of $500, or about $17 per year. Once you start using this method, you must continue to use it for all U.S. Bonds you own (E, EE, and I) forever, unless you request, and receive, permission from the IRS to change back to cash basis method of reporting.

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Does the accrual method make sense? In theory it may, but the amount of recordkeeping necessary would quickly defeat any gain in tax savings. Only in rare cases would it be fruitful to make the accrual election. A notable exception may be in the case of a decedent owning a significant amount of savings bonds where the executor (executrix, or personal representative of the estate) would make the election to have the interest taxed in the decedents final income tax return.

Note that if you plan to cash your bonds in the same year you will pay for higher educational expenses, you may want to use the cash method because you may be able to exclude the interest from your income. That is, if the proceeds are used for qualified educational expenses.

The taxation discussion above is for Federal income tax. The good news is that most states, including Pennsylvania, excludes such U.S. Savings Bond interest from taxation, regardless of the method used.

Lastly, as to the investment merits, the EE bond rates are bouncing along the bottom as are most other money account rates of only a fraction of a percent (currently about .20%), but the I bonds currently are at 1.76% and carry a unique feature in that the rate changes with the inflation rate. As to safety, lets all hope they are as safe as theyve been since President Franklin D. Roosevelt signed the legislation authorizing the first bonds in 1935.

Bruce Baer, CPA is managing partner of Baer and Company, CPAs located in Morgantown. Questions and comments can be directed to Bruce at Bruce@BaerAndCompanyCPAs.com.

Disclaimer Baer and Company, CPAs advertises with Journal Register Co. publications.

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