Savings Bonds: Easy To Forget?

Saturday, June 25, 2011 03:15
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Savings Bonds: Easy To Forget?

Tags: bonds | retirement income

Many investors, especially retirees, have accumulated numerous United States savings bonds over the years. In a typical situation, savings bonds have been accumulated through gifts and periodic purchases. The bonds are then set aside in a drawer, safe deposit box or shoe box—and forgotten about.

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Series E and EE bonds accrue interest, which, in turn, increases redemption value. Thus, although savings bonds will increase in value, no current income will be produced. If a retiree is in need of additional cash flow, he or she may be tempted to redeem savings bonds.

A savings bond that is redeemed for cash value will usually cause the tax recognition of all accrued interest income. The tax laws allow the holder of a savings bond to elect to report accrued interest as taxable income each year. Since this election accelerates tax and binds the taxpayer forever, most taxpayers will choose not to elect current taxation of savings bond interest. Thus, a retiree cashing in a bond in order to free up cash may face an unexpectedly high tax liability.

EXAMPLE

Henry purchased ten $1,000 Series EE bonds for $500 each many years ago. Henry retires at age 62 and decides to redeem his bonds, now worth $17,000. Since he did not elect current taxation of savings bond interest, Henry will recognize all accrued interest as taxable income in the year of redemption. Thus, Henry will recognize interest income of $12,000 ($17,000 redemption proceeds less $5,000 originally paid). Since U.S. savings bond interest is not taxable for state tax purposes, Henry will pay Federal tax only. Assuming a Federal tax rate of 28 percent, Henry will incur a tax liability on the savings bond interest of $3,360.

If savings bonds are forgotten for too long a period of time, detrimental financial results may occur. Series E and Series EE bonds cease to earn interest at ‘‘maturity.’’ For example, Series EE bonds mature after 30 years. A forgotten bond that has ceased to earn interest will actually lose value, when inflation is considered. Thus, it is important to monitor the status of Series E and EE bonds held to ensure that they are still accruing interest.

Prior to September 1, 2004, Series E and Series EE bonds could be exchanged for an equivalent amount of Series HH bonds without recognition of income. However, after August 31, 2004, the Treasury ceased to issue Series HH bonds.

In general, savings bond interest is credited only two times per year. Thus, a bond holder who is considering redeeming a bond should pay attention to the timing of interest postings. A bond that is redeemed shortly before the posting of interest will essentially forfeit almost six months of interest earnings.

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