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Does estate or heir pay the tax on savings bonds?
Albuquerque Journal
10/20/2005
Q: I have U.S. Savings Bonds in joint name with my recently
deceased mother, who paid everything into these bonds. My
understanding is that the tax liability, upon redemption, goes
against the person who paid in. I am wondering if the tax liability
would go against my mother's estate? -- J.L., Tijeras
A: Fair warning, Readers -- take a big gulp of coffee before
tackling this tantalizing tax topic!
Generally inheritances are not considered income to the
recipient. One important exception is assets that are tax-deferred
or have not yet been taxed, such as U.S. Savings Bonds, certain
pensions, IRAs and annuities. These assets do not receive a stepped-
up basis at the death of their owner and once these assets are
redeemed or withdrawn by the beneficiaries, the income is considered
"income in respect of a decedent" (IRD).
You hit the nail on the head when you said "upon redemption." It
is surprising how much interest older bonds earn upon redemption.
For example, a 30-year-old $500 bond can generate over $2,000 in
interest income upon redemption.
The answer to your question depends upon who redeems the bonds.
In the interest of good public service, I read large portions of IRS
Publication 559, Survivors, Executors, and Administrators, that
addresses this topic. I learned that taxpayers may defer recognizing
the interest on E, EE and I bonds until the bonds are cashed; or,
alternatively, they may elect to report the accrued interest each
year. Most people choose deference.
The IRD issue can arise when a taxpayer, who has deferred the
interest, dies holding the bonds, as in your case. At this point,
the personal representative may elect to recognize the accrued
interest on the decedent taxpayer's final individual income tax
return rather than have the beneficiaries be responsible for the tax
on the interest. Personal representatives who are unfamiliar with
tax laws may not even know they have this choice. This election must
be made by the due date, including extensions, for filing the
decedent's final return.
If the election is made, all of the interest earned on the bonds
before the decedent's death would be included on the decedent's
income tax return. The estate or beneficiary would then include on
its return only the interest earned after the date of death.
If an election is not made, the interest earned to the date of
death is IRD and is not included in the decedent's final return.
According to Publication 559, IRD must be included in the income of
one of the following:
The decedent's estate, if the estate receives it;
The beneficiary, if the right to income is passed directly to the
beneficiary and the beneficiary receives it; or
Any person to whom the estate properly distributes the right to
receive it.
Including the bond income on the decedent's final income tax
return may be the best move for decedents who do not have much
income and who may have significant medical deductions (including
long term care costs) in their final year, reducing their taxable
income. Recognizing the interest on the decedent's final tax return
often results in lower total tax than if beneficiaries in higher tax
brackets pay the tax on the interest when the bonds are later
cashed. For large estates on which estate tax will be due, the
election may also help because the income tax due as a result of
recognizing the interest on the decedent's final return reduces the
total value of the estate, thereby reducing the estate tax due.
One way a bond owner can continue to defer income tax liability
is not to redeem the bonds. An owner could leave the unredeemed
savings bonds to qualified charities by will, trust or beneficiary
designation. Since qualified charities usually do not pay income
tax, the charity can receive the full benefit of the U.S. savings
bonds upon the owner's death.
For those who choose to redeem the bonds and pay the federal
income taxes, at least in New Mexico, taxpayers do not have to pay
state income tax on the bond interest income.
Publication 559 addresses IRD, as well as many other estate tax
topics in depth. You can read the publication on line at www.irs.gov
or call 1-800-829-3676 to request a free copy.
Since I can only give general information in this column, you
should consult a knowledgeable tax attorney or CPA about the best
choice for your mother's estate.
Thanks to my CPA friend M.Z. for greatly improving this column.
Write to Judge Rudd at P.O. Box
36011, Albuquerque, N.M., 87176-6011, or e-mail jueznm@aol.com.
Because of high volume of letters,
the judge may not personally answer
all questions submitted.
(C) 2005 Albuquerque Journal. via ProQuest Information and Learning Company; All Rights Reserved
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