Pay taxes on EE bonds now or later?

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totalnoobie
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Joined: Thu Dec 31, 2015 10:33 pm

Pay taxes on EE bonds now or later?

Post by totalnoobie » Sat Sep 22, 2018 6:14 pm

Hello sages,

SIL recently discovered he has ~20k in EE bonds from the early 1990s that are currently paying 4% each year with final maturity in the early 2020s, wondering if he and DD should start paying taxes on the interest this year and every year going forward. The pro would be they are in a low tax bracket for a couple more years before both graduate from their respective graduate programs. The con would be no longer getting to defer taxes and having to pay a large sum this year and smaller sums every year after that.

Anyone have experience with this and/or know how to value the tax deferral aspect against the potential tax bracket arbitrage benefit?

tomd37
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Re: Pay taxes on EE bonds now or later?

Post by tomd37 » Sat Sep 22, 2018 6:22 pm

In my opinion the owner should look closely at his particular tax situation. The interest must be reported in the year of maturity even though he may not cash them in. What impact might that have on his taxes in the year of maturity compared to start reporting the interest in prior years and continuing to report any additional interest in subsequent years?

I am aware of a particular situation where such interest was not reported on similar bonds of the same age and now that person's tax on social security benefits is going to be significantly impacted. Had the person chosen another method of reporting the interest over a number of earlier years the impact would not be so significant.
Tom D.

aristotelian
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Re: Pay taxes on EE bonds now or later?

Post by aristotelian » Sat Sep 22, 2018 7:04 pm

Can't they be used tax free for education? Cash them now and pay no tax.

Dottie57
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Re: Pay taxes on EE bonds now or later?

Post by Dottie57 » Sat Sep 22, 2018 7:08 pm

aristotelian wrote:
Sat Sep 22, 2018 7:04 pm
Can't they be used tax free for education? Cash them now and pay no tax.
I think these are the bonds that double in value at maturity. Don’t cash them in until that time comes.

totalnoobie
Posts: 93
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Re: Pay taxes on EE bonds now or later?

Post by totalnoobie » Sat Sep 22, 2018 7:11 pm

Thanks for the replies.

1) Yes, EE bonds can be used for education, but DD in graduate program with stipend and SIL is apparently set for costs through parental 529.

2) If only looking at taxes, paying taxes now and then year by year is better because they will be in a much higher tax bracket in 3-5 years. But isn't there a benefit also to tax deferral? The money they could use to pay taxes now could be otherwise saved/invested? Not sure how to compare the two sides...

3) All bonds are already past the doubling point, but they get a guaranteed 4% interest every year..

aristotelian
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Re: Pay taxes on EE bonds now or later?

Post by aristotelian » Sat Sep 22, 2018 7:45 pm

totalnoobie wrote:
Sat Sep 22, 2018 7:11 pm

2) If only looking at taxes, paying taxes now and then year by year is better because they will be in a much higher tax bracket in 3-5 years. But isn't there a benefit also to tax deferral? The money they could use to pay taxes now could be otherwise saved/invested? Not sure how to compare the two sides...
They will have to report and pay taxes on the interest when the bonds reach final maturity in a few years. After final maturity, the bonds will no longer earn interest and taxes have to be paid whether you like it or not. I would cash them in while they are still in school and in a low tax bracket. Consider using the 529 for something else, maybe their kids.

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EyeYield
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Re: Pay taxes on EE bonds now or later?

Post by EyeYield » Sat Sep 22, 2018 8:57 pm

totalnoobie wrote:
Sat Sep 22, 2018 6:14 pm
Hello sages,

SIL recently discovered he has ~20k in EE bonds from the early 1990s that are currently paying 4% each year with final maturity in the early 2020s, wondering if he and DD should start paying taxes on the interest this year and every year going forward. The pro would be they are in a low tax bracket for a couple more years before both graduate from their respective graduate programs. The con would be no longer getting to defer taxes and having to pay a large sum this year and smaller sums every year after that.

Anyone have experience with this and/or know how to value the tax deferral aspect against the potential tax bracket arbitrage benefit?
Early 1990(s)? That could be interpreted as plural, meaning multiple years, or do they all reach final maturity in the same calendar year? If the bonds are spread out over a number of years, it may not be such a big tax hit for any given year.

You have to figure out if, depending on the tax bracket, giving up a guaranteed 4% now is worth the tax savings later.

5 year CDs are paying about 3.40% now, so if they reach 4% in the next couple of years, it might be wise to redeem a few early every year and convert them to CDs and stagger them 5 years in the future each year, thus spreading out the maturity dates so no one year sees a big tax hit.

As has been mentioned, it depends on the tax bracket and how much room one has until hitting the next one.
"The stock market is a giant distraction from the business of investing." - Jack Bogle

OnTrack
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Re: Pay taxes on EE bonds now or later?

Post by OnTrack » Sun Sep 23, 2018 1:12 am

EyeYield wrote:
Sat Sep 22, 2018 8:57 pm
totalnoobie wrote:
Sat Sep 22, 2018 6:14 pm
Hello sages,

SIL recently discovered he has ~20k in EE bonds from the early 1990s that are currently paying 4% each year with final maturity in the early 2020s, wondering if he and DD should start paying taxes on the interest this year and every year going forward. The pro would be they are in a low tax bracket for a couple more years before both graduate from their respective graduate programs. The con would be no longer getting to defer taxes and having to pay a large sum this year and smaller sums every year after that.

Anyone have experience with this and/or know how to value the tax deferral aspect against the potential tax bracket arbitrage benefit?
Early 1990(s)? That could be interpreted as plural, meaning multiple years, or do they all reach final maturity in the same calendar year? If the bonds are spread out over a number of years, it may not be such a big tax hit for any given year.

You have to figure out if, depending on the tax bracket, giving up a guaranteed 4% now is worth the tax savings later.

5 year CDs are paying about 3.40% now, so if they reach 4% in the next couple of years, it might be wise to redeem a few early every year and convert them to CDs and stagger them 5 years in the future each year, thus spreading out the maturity dates so no one year sees a big tax hit.

As has been mentioned, it depends on the tax bracket and how much room one has until hitting the next one.
I don't think that staggering CDs maturity avoids a big tax hit. Most CDs credit interest at least once a year. There are zero coupon CDs, but even for these the interest that you don't receive is taxable each year.
https://www.bankrate.com/financing/inve ... -are-they/

cas
Posts: 346
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Re: Pay taxes on EE bonds now or later?

Post by cas » Sun Sep 23, 2018 6:39 am

totalnoobie wrote:
Sat Sep 22, 2018 6:14 pm
SIL recently discovered he has ~20k in EE bonds from the early 1990s that are currently paying 4% each year with final maturity in the early 2020s, wondering if he and DD should start paying taxes on the interest this year and every year going forward.
I deal with this issue, although in a different context: elderly parents own(ed) mid-1980s to early 1990s vintage EE bonds and I need to figure out the optimal path for redeeming them without going over the next IRMAA (increased Medicare premiums) threshold, yet keeping that nice 4% yield as long as possible. (Yes, all the ones maturing 2017 and before have already been properly redeemed and reported.)

As far as I can figure out, these are the options:

Option 1: The pay-for-education option. There are lots of little gotchas associated with this option, and I think this is the little gotcha that will likely rule out this option for the OP's SIL ("son-in-law", right? ("sister-in-law" doesn't seem to fit the context):
You [ the bond owner] must be at least 24 years old on the first day of the month in which you bought the bond(s).
Source: https://www.treasurydirect.gov/indiv/pl ... cation.htm

I'm guessing that if they are in graduate school, your son-in-law and daughter are in late 20s, early 30s? And there is no way that your son-in-law was 24 in the early 1990s when the bonds were purchased?

However, this does bring up the questions of "How did your SIL come into possession of these bonds?" It is certainly possible that a parent or grandparent purchased them in his name when he was a child, and he has owned them all along. But - if, by any chance, they were inherited - especially if inherited relatively recently - he'll probably want to verify whether or not all the accrued interest for those bonds was reported on the final tax return (or estate tax return, if any) of the person he inherited them from. Reporting the accrued interest on a decendent's final tax return is an option - might have happened; might not have happened. If some tax may have already been paid on the decedents final tax return, see this post for the nitty gritty on IRS documentation on how your SIL avoids paying tax on the same interest twice: "Steps for Redeeming/Reporting/Paying interest & penalties for inherited matured EE Series Savings Bonds" viewtopic.php?t=239929#p3752731

Options 2. The "just-wait-until-they-mature" option.
Option 3. The "Hold to maturity, but switch from deferring tax to paying tax annually. (all accrued interest on all EE bonds must be reported on taxes in the year the switch is made)" option.
Option 4. The "Gradually redeem some bonds early (keeping under some pre-selected tax threshold), re-invest proceeds (minus tax paid on interest) into something else"

As far as I can tell, choosing among these options is a matter of spreadsheets and figuring out which option will leave the most after-tax money on the date that the EE bonds would have matured if they had been held to maturity. (This is assuming that the total amount of interest earned by all the bonds is worth the trouble of setting up the spreadsheets to start with.)

And I think maybe the main point of your question to the forum is how to set up the compounding calculations in the spreadsheet for the various options.

I have a spreadsheet for myself to help figure out my parents' situation, but I'm not confident enough in it to share it. Broadly my method was

1. figure out what the interest would be on an EE bond held to maturity (using a compound interest calculation), then subtract out (estimated) taxes (and (estimated) extra IRMAA surcharges, in my case) that would be owed in that year.

2. Figure out what interest would be on an EE bond if I redeemed the bond this year, then subtract taxes that would be owed this year. Choose something to reinvest the after-tax amount in. Use compound interest equation - using an after-tax-equivalent-yield for the new investment - to figure out the value of the new investment on the date that the EE bond would have matured if I had held it to maturity. (In my case, it would be reinvested in some sort of bond/CD so figuring out the new after-tax-equivalent yield is a lot easier than if I were to reinvest in stocks, like a younger person might. It is also easier for me because there is less uncertainly in what my retired parents' tax rate is likely to be in the early 2020s vs a younger couple who will be working in an as-yet-unknown-job-with-unknown-salary in the early 2020s.)

3. Compare final after tax $ return of Steps 1 and 2.

The option that the OP mentions - switching from deferring the interest to reporting the interest annually - wasn't a good option for my parents' situation, so I don't have any spreadsheets set up for that option.

markcoop
Posts: 801
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Re: Pay taxes on EE bonds now or later?

Post by markcoop » Sun Sep 23, 2018 6:59 am

cas wrote:
Sun Sep 23, 2018 6:39 am
However, this does bring up the questions of "How did your SIL come into possession of these bonds?" It is certainly possible that a parent or grandparent purchased them in his name when he was a child, and he has owned them all along. But - if, by any chance, they were inherited - especially if inherited relatively recently - he'll probably want to verify whether or not all the accrued interest for those bonds was reported on the final tax return (or estate tax return, if any) of the person he inherited them from. Reporting the accrued interest on a decendent's final tax return is an option - might have happened; might not have happened.
I was just wondering in general is it advantageous for an estate to pay income tax on accrued interest from bonds and report on the final tax return or estate tax return?
Mark

cas
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Joined: Wed Apr 26, 2017 8:41 am

Re: Pay taxes on EE bonds now or later?

Post by cas » Sun Sep 23, 2018 2:46 pm

markcoop wrote:
Sun Sep 23, 2018 6:59 am
cas wrote:
Sun Sep 23, 2018 6:39 am
he'll probably want to verify whether or not all the accrued interest for those bonds was reported on the final tax return (or estate tax return, if any) of the person he inherited them from. Reporting the accrued interest on a decendent's final tax return is an option - might have happened; might not have happened.
I was just wondering in general is it advantageous for an estate to pay income tax on accrued interest from bonds and report on the final tax return or estate tax return?
I'm not an expert, but I suspect it is situation-dependent. For example, if the owner of the bonds passed away early in the year or if he/she had lots of deductible medical expenses in their final year, they may have very little taxable income in their final year. Adding in the accrued interest from the EE bonds may still result in a 0% or very low tax rate - or at least a tax rate lower than the tax rate of the person who inherits the bonds.

On the negative side, when the EE bonds do finally mature (or are redeemed early by the person who inherited them), the 1099-INT that is issued will show the *entire* amount of interest earned on the bonds (without any adjustment for the part of the interest where the tax was already paid.) It is completely up to the person who inherited the bonds to know/remember (possibly many years later) that some interest had already been reported to the IRS (and tax paid), then report the adjustment to the interest properly on their IRS 1040. I would assume that if that person was audited, they would also need to to have the relevant pages from the original owner's final tax return to prove that the tax had already been paid for part of the interest. I would not be at all surprised if the IRS ends up getting paid tax on the same interest twice in vast numbers of these cases. (Once when the original owner died. Once when the person who inherited the bonds redeems them and didn't know or remember that they were supposed to adjust the interest on the 1099-INT that they receive.)

totalnoobie
Posts: 93
Joined: Thu Dec 31, 2015 10:33 pm

Re: Pay taxes on EE bonds now or later?

Post by totalnoobie » Mon Oct 01, 2018 7:14 pm

cas wrote:
Sun Sep 23, 2018 6:39 am
totalnoobie wrote:
Sat Sep 22, 2018 6:14 pm
SIL recently discovered he has ~20k in EE bonds from the early 1990s that are currently paying 4% each year with final maturity in the early 2020s, wondering if he and DD should start paying taxes on the interest this year and every year going forward.
I deal with this issue, although in a different context: elderly parents own(ed) mid-1980s to early 1990s vintage EE bonds and I need to figure out the optimal path for redeeming them without going over the next IRMAA (increased Medicare premiums) threshold, yet keeping that nice 4% yield as long as possible. (Yes, all the ones maturing 2017 and before have already been properly redeemed and reported.)

As far as I can figure out, these are the options:

Option 1: The pay-for-education option. There are lots of little gotchas associated with this option, and I think this is the little gotcha that will likely rule out this option for the OP's SIL ("son-in-law", right? ("sister-in-law" doesn't seem to fit the context):
You [ the bond owner] must be at least 24 years old on the first day of the month in which you bought the bond(s).
Source: https://www.treasurydirect.gov/indiv/pl ... cation.htm

I'm guessing that if they are in graduate school, your son-in-law and daughter are in late 20s, early 30s? And there is no way that your son-in-law was 24 in the early 1990s when the bonds were purchased?

However, this does bring up the questions of "How did your SIL come into possession of these bonds?" It is certainly possible that a parent or grandparent purchased them in his name when he was a child, and he has owned them all along. But - if, by any chance, they were inherited - especially if inherited relatively recently - he'll probably want to verify whether or not all the accrued interest for those bonds was reported on the final tax return (or estate tax return, if any) of the person he inherited them from. Reporting the accrued interest on a decendent's final tax return is an option - might have happened; might not have happened. If some tax may have already been paid on the decedents final tax return, see this post for the nitty gritty on IRS documentation on how your SIL avoids paying tax on the same interest twice: "Steps for Redeeming/Reporting/Paying interest & penalties for inherited matured EE Series Savings Bonds" viewtopic.php?t=239929#p3752731

Options 2. The "just-wait-until-they-mature" option.
Option 3. The "Hold to maturity, but switch from deferring tax to paying tax annually. (all accrued interest on all EE bonds must be reported on taxes in the year the switch is made)" option.
Option 4. The "Gradually redeem some bonds early (keeping under some pre-selected tax threshold), re-invest proceeds (minus tax paid on interest) into something else"

As far as I can tell, choosing among these options is a matter of spreadsheets and figuring out which option will leave the most after-tax money on the date that the EE bonds would have matured if they had been held to maturity. (This is assuming that the total amount of interest earned by all the bonds is worth the trouble of setting up the spreadsheets to start with.)

And I think maybe the main point of your question to the forum is how to set up the compounding calculations in the spreadsheet for the various options.

I have a spreadsheet for myself to help figure out my parents' situation, but I'm not confident enough in it to share it. Broadly my method was

1. figure out what the interest would be on an EE bond held to maturity (using a compound interest calculation), then subtract out (estimated) taxes (and (estimated) extra IRMAA surcharges, in my case) that would be owed in that year.

2. Figure out what interest would be on an EE bond if I redeemed the bond this year, then subtract taxes that would be owed this year. Choose something to reinvest the after-tax amount in. Use compound interest equation - using an after-tax-equivalent-yield for the new investment - to figure out the value of the new investment on the date that the EE bond would have matured if I had held it to maturity. (In my case, it would be reinvested in some sort of bond/CD so figuring out the new after-tax-equivalent yield is a lot easier than if I were to reinvest in stocks, like a younger person might. It is also easier for me because there is less uncertainly in what my retired parents' tax rate is likely to be in the early 2020s vs a younger couple who will be working in an as-yet-unknown-job-with-unknown-salary in the early 2020s.)

3. Compare final after tax $ return of Steps 1 and 2.

The option that the OP mentions - switching from deferring the interest to reporting the interest annually - wasn't a good option for my parents' situation, so I don't have any spreadsheets set up for that option.
Thank you for such a comprehensive reply! The decision is between Options 2, 3, and 4. And you are correct, I suppose the gist of my query is whether someone calculated out the differences and if one was usually better than the other. Given that they still have some 15% tax bracket room, I suspect the right choice will be either option 3 or 4 to fill out the 15% tax bracket and forgoing a bit of tax deferral (which would eventually lead to paying in the 25% tax bracket or higher)...

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