HOME   TIPS CALENDAR NEWSLETTER   Need an Accountant For Your Taxes Gerald Kramer The AZ CPA 4531 N 16th St Suite 126 Phoenix, AZ 85016 (602) 264-9331 Fax: (602) 279-1766 Time Running out for exchanging savings bond to save taxes. Current holders of Series EE/E savings bonds will no longer be able to exchange them for HH bonds after August 31, 2004 when Treasury will cease issuing such bonds. This means that holders of EE/E bonds will lose the opportunity to defer reporting accrued interest on their EE/E bonds by exchanging them for HH bonds. Such exchanges can permit tax deferral on accrued interest to continue foe another 20 years after the exchange. Background: Interest on Series HH/H bonds is exempt from state and local taxes but must be reported on the owner's Federal income tax return for the year it's earned. (Code Sec. 61 (a)(4)) Interest on Series EE/E bonds also is exempt from state and local income taxes. But a purchaser of an EE bond may report interest earned on the savings bonds each year or defer interest reporting until the bond is cashed, stops earning interest at final maturity, or is disposed of in some other way. GLK observation: Most individuals holding EE/E bonds choose to defer reporting of interest. The owner, co-owner, or surviving beneficiary of Series EE/E bonds can exchange them for Series HH bonds if the bonds being exchanged are: At least 12 months old Worth at least $500, and Haven't matured for longer than a year There is a tax advantage to exchanging EE/E bonds for HH bonds. If the EE/E bond holder has chosen to defer reporting of interest on the bonds being exchanged, as is typically the case, the exchange will mean that interest reporting can continue to be deferred until the HH bonds received in the exchange are cashed, stop earning interest in 20 years when they reach final maturity, or are reissued in a reportable event. The amount of the tax-deferred interest included in the value of each HH bond received in an exchange for EE bonds is shown on the front of the HH bond. The current interest that is paid every six months on the HH bonds, however, is currently taxed. Planning considerations. Whether or not an individual who is holding EE/E bonds on which interest reporting has been deferred should exchange them before September 1, 2004 to continue the deferral for up to 20 years depends on a number of factors including the following: The amount of interest that has been deferred from reporting. If only a small amount is involved, deferral may not be so valuable. On the other hand, if a large amount is involved, continuing the deferral may be worth a great deal. The final maturity date of the bonds. If the bonds have a long way to go before reaching final maturity, deferral may not be warranted. On the other hand, if the bonds are close to reaching final maturity, there is a greater reason to consider exchanging them. The interest rate on the bonds. If the interest rate on the bonds is much higher than the 1.5% rate paid on new HH bonds, then deferral may be contra-indicated. The expected tax bracket when the bonds would be cashed if not exchanged. Deferral should be considered if the individual expects to be a high tax bracket when the EE/E bonds would be cashed if they are not exchanged. On the other hand, if the individual will be in a low tax bracket or otherwise will be able to shelter much or all of his income from tax, deferral would not be needed. Need for the funds. In choosing whether to exchange or cash bonds, individuals obviously must consider whether they will need the funds, for example, to help meet living expenses during retirement. Alternative investments. An individual may be able to achieve a higher after tax return by cashing rather than exchanging the bonds and using the funds to purchase an alternative investment, such as dividend paying stock, which itself has tax advantages in that the dividends may qualify to be taxed at a maximum rate of 5% or 15%, as might any gain on the stock. Other ways to save taxes. Exchanging EE/E bonds for HH bonds can save taxes in ways other than deferral. Tax savings may be possible even if the HH bonds won't be held until maturity or will be cashed in well before maturity. The potential tax savings result from the individual's ability to control the timing of income. For example, assume a client has $100,000 of deferred interest on EE bonds that will soon reach final maturity in a single year. If the client does not exchange those bonds for HH bonds before September 1, 2004, he will have $100,000 of interest income in a single year with these potentially disastrous tax consequences: Social security benefits: If he is collecting social security benefits, this interest income will cause 85% of his social security benefits to be taxed. Dividends. If he holds dividend-paying stocks, this interest income will cause his qualified dividends to be taxed at 15% rather than at 5%. Capital gains. If he sells stocks or other capital assets at a net gain, this interest income will cause his adjusted net capital gain to be taxed at 15% rather than at 5%. Medical expense deduction. If he has potentially deductible medical expenses, this interest income will increase his adjusted gross income, which in turn, can reduce or eliminate any medical expense deduction to which he may be entitled, taking into account the 7.5% floor. Other tax breaks geared to AGI. This interest income could reduce and in some cases eliminate other tax breaks that are geared to AGI including, depending on the taxpayer's specific situation: casualty loss deductions; deduction for traditional IRA contributions; ability to make Roth IRA contribution or rollover; student loan interest deduction; miscellaneous itemized deductions, itemized deductions affected by the overall limitation on itemized deductions; personal exemptions; the credit for child and dependent care expenses; the child credit; the earned income credit; the adoption credit; education credits; the exclusion for employer-provided adoption assistance; the exclusion for interest on savings bonds used for education; and the deduction for high education expenses. These negative tax consequences could arise, perhaps to a lesser extent, even if the EE bond interest will be reportable over two or three years instead of one year. However, the taxpayer can avoid these negative tax consequences by exchanging the EE bonds for HH bonds. This will put him in a position to control the timing of his income from the deferred interest on the EE bonds that carries over to, and is shown on the front of, the HH bonds. He will be able to choose the amount of HH bonds that he will cash each year and thus how much deferred EE bond interest he will have to report each year. Thus, taking into account his other income, in many cases, he will be able to minimize the amount of his social security benefits that he will be taxed, keep his qualified dividends and adjusted net capital gain from being taxed at a rate above 5%, maximize his medical expense deductions, and keep the other tax breaks listed above from being reduced or eliminated.