Series I Bonds: accrual method for the kiddie tax

Most of us know that Series I Bonds (along with other US Treasury issues) are exempt from State Tax. They can also be exempt from Federal tax in certain circumstances. This piece walks through how a child can use a §454 election to be taxed annually — potentially making the proceeds free of both Federal and State tax — and how to make the election.

Reversing the decision can be more convoluted than the original choice, and if there is other child income involved, things get more complicated.

Series I Bonds are exempt from State income tax. For Federal tax purposes, there are two methods of taxation:

• Tax is deferred until maturity (or when you redeem them, if sooner) and then is a lump-sum event. This is the default method, using the Cash Basis approach.
• Tax is recognized annually. This is an elective method using the Accrual Basis approach.

If you do nothing, you'll be using cash basis.

Changing methods

Changing from cash to accrual is relatively easy and is outlined below. Changing from accrual back to cash basis is more convoluted, and is outlined in IRS Pub 550.

Note that the election applies to all bonds connected to a particular Tax ID Number, so you cannot elect this for a single bond when you own multiple.

When and why to change to accrual

If we take $10,000 as an initial investment, and compound it by 5% annually (in reality, returns are variable), we would have the following:

Cash vs. accrual taxation, side by side

(Based on a child with no other earned income during the 15 years.)

In both scenarios, Mr. Cash-Based and Mr. Accrual-Based would receive a 1099 in the redemption year (year 15). There are no other 1099s received prior to this. The person who elected into accrual basis would offset that 1099 by reducing it for interest already taxed:

But they already paid tax — isn't it a wash?

That's the logic when we present this to the IRS. We're saying that the taxpayer (the child in this case) has already paid the necessary tax each year, and cannot be subject to tax on the proceeds in year 15. The nuance is that the tax recognized in the preceding 14 years was taxed at zero. The reason this works is that the interest earned is low enough to receive $0 tax treatment, and is also under the Kiddie Tax limit.

This also illustrates how other earned income can be a problem in this strategy — though it might still be worth considering.

Timeline of events

The following illustrates the timeline of events from acquisition to redemption:

Key steps

1. Ensure that the bond is actually transferred to the child.
2. Opt in to the Accrual method via §454 election for the child (more below).
3. Track earnings (but do not file a tax return unless it is necessary for other reasons, such as other income earned).
4. Use your records to offset the 1099 received at redemption.

How to make the §454 election

There is no formal instruction for this. Guidance simply states you make the election by filing a statement with the tax return (of the child). You'd need to file a return in the initial year, but in subsequent years a filing is only necessary if total income exceeds the threshold for Kiddie Tax filing. Suggested wording:

Taxpayer John Doe, SSN 123-45-6789 is making a §454 election to be taxed annually, under the accrual method for Series I Bonds.

Then print to PDF and attach to the e-filed return of the child.

What if I bought bonds three years ago?

It isn't too late. You can elect into the Accrual method at any time. When you do, you have to recognize all income accrued thus far. Using the same example numbers, but with a year-three election:

Here, the child would report a larger amount of interest as we have three years of accumulated interest. This would result in reporting $1,576, subject to tax of $33.

A quick foray into Kiddie Tax

Kiddie tax is a tax on unearned income of the child. There are two thresholds to be mindful of:

1. Child Standard Deduction.
2. Child Tax Bracket (a second amount above the standard deduction).

If a child has unearned income at or below the standard deduction, there's no tax and no filing requirement (unless there's earned income or capital gain transactions). Above the deduction but below the second threshold, the child is taxed at the child's tax rate. Above the second threshold, the child must use the marginal tax bracket of their parent when calculating the tax due.

Using the example numbers above, $1,576 of unearned income produces $33 of tax because:

• $1,576 unearned income
• Standard deduction
• Remaining taxable income
• Tax at the child's 10% rate

What if there is other Kiddie Tax income?

The reason this strategy works is that each annual payment is below the standard deduction (which tends to increase annually for inflation). If the child had other unearned income, the election to be taxed annually might be inferior. This depends on the amount and the timing of the income. If combined with the income from the Series I Bonds it stays under the limit, it's still worth doing. But if the income is substantial in these years, it might be better to defer recognition of gain until the future.

Conclusion

Opting in to annual taxation can be a good option in certain situations — most often with children. Note these would be a countable asset for student aid, which is why the child might want to redeem them before they mature. At that point it's possible to move the proceeds (tax free) into a 529-UTMA account to reduce their countable value to 5.64% of face. There are some other benefits for college-related expenses, but these don't apply for a bond held by the child, so they aren't being lost by claiming the interest tax-free and shifting the assets into a 529 wrapper prior to college.