DEATH, TAXES, AND U.S. SAVINGS BONDS

In helping executors administer estates, I have learned that there are three things that are certain in life – death, taxes, and each of us, if we live long enough, will buy and die with a U.S. savings bond. And these ubiquitous investment vehicles raise many questions for the executor.

As those of you who have already bought your bonds know, there are many different “series” of bonds – E bonds, EE, H, HH, and I. Each series has its own purpose, its own rules regarding taxation, and its own procedures for redemption.

Series E/EE bonds are income-accruing securities. Interest is periodically added to the amount originally paid, establishing the bond’s current redemption value. As interest accrues, the value of the bond increases. When cashed, the bondholder receives the redemption value – which represents the return of his original investment plus the interest that he earned while he held the bond.

Series H and HH bonds pay income presently. The redemption value of the bonds remains constant at the amount invested. Interest is paid to the bondholder every six months. When the bondholder cashes an H/HH bond, he receives his original investment back.

I Bonds are designed for investors seeking to earn a guaranteed rate of return. I Bonds accrue interest. The interest is added to the bond monthly and paid when the bond is cashed. I Bonds are sold at face value – you pay $50 for a $50 bond – and the bond grows in value with inflation-indexed earnings, for up to 30 years.

Series E/EE bonds can be redeemed at financial institutions, such as a bank. Series H/HH bonds can only be redeemed through a federal reserve bank.

To redeem either bond, the executor will need to produce documentation that he is authorized to act on behalf of the estate. This documentation is obtained from the surrogate’s office when the Will is probated. The executor will also need to sign the back of the bonds, in his capacity as executor of the estate, and his signature will need to be guaranteed. A “signature guarantee” is similar to a notary stamp; however, unlike a notary, only financial institutions are capable of guaranteeing a signature.

With E/EE bonds, the process of redemption will be over with these acts. With H/HH bonds, the bank – at least an ordinary bank – cannot redeem these bonds. Instead, the bonds must be mailed to the applicable federal reserve bank for redemption.

Since H/HH bonds earn interest on semi-annual cycles, the executor will have to indicate whether he wants the bonds redeemed immediately, which could cause a loss of one cycle’s interest, or whether he wants redemption deferred until the current interest cycle has ended. Deferring redemption will result in the bonds earning the interest due from the present interest cycle.

If this wasn’t enough, things get even more esoteric, because now decisions must be made about taxation. The taxation of bonds can be troublesome. Since series E/EE bonds accrue interest, tax may have but probably wasn’t paid annually on the interest accrued. Though taxpayers can claim each year’s accrued interest on their annual tax returns, they don’t have to, and most don’t. That means that all of the tax on the accrued interest is owed when the bonds are redeemed.

Since the bonds typically aren’t redeemed until after the owner dies, it would seem obvious that his estate must pay the income tax owed, but this is incorrect. Interest that accrued prior to death could be reported on the decedent’s final income tax return – if the executor makes an election with the IRS to do this. The election is terribly important because estates pay tax at “compressed brackets,” which means that estates typically pay more income tax than do individuals.

With H/HH bonds, income was paid currently, so the income was taxed annually. But the decedent may have converted E/EE bonds to obtain the H/HH bonds. At the time of conversion, no tax was paid on the E/EE bonds. Instead, the government deferred collection of this tax until the H/HH bonds were redeemed.

So, this means that even H/HH bonds can produce tax for the estate. Once again, the executor will need to make an election to claim this interest on the final, personal income tax return, thereby saving the beneficiaries of the estate money.

U.S. savings bonds are often tucked away in safe deposit boxes, desk drawers, and forgotten folders for decades. Reviewing how these bonds are titled, redeemed, and incorporated into an estate plan can help families avoid unnecessary confusion and missed financial opportunities later on.