Series I Bonds accrual method for kiddie tax
Most of us know that Series I Bonds (along with other US Treasury issues) are exempt from State Tax. However, they can also be exempt from Federal tax in certain circumstances. This post illustrates how a child can use a §454 election to be taxed annually may result proceeds that are free of both Federal and State tax, and how to make the election. Keep in mind that reversing the decision can be more convoluted than the original decision to be taxed annually, and if there is other child income involved, things get a bit 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.
Therefore, if you do nothing, you'll be using cash basis.
Changing from cash to accrual is relatively easy, and will be outlined below. Changing from accrual back to cash basis is more convoluted, and is outlined in 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 the Accrual method
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 of the above
(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 in our scenario). 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, so isn't it a wash?
That's the logic when we present this to the IRS. We are 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 that was 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 also is under the Kiddie Tax limit.
This also illustrates how other earned income can be a problem in this strategy (but still might be worth considering).
Timeline of events
The following illustrates the timeline of events from acquisition to redemption:
- Ensure that the bond is actually transferred to the child.
- Opt-into Accrual method via §454 election for the child (more below).
- Track earnings (but do not file a tax return unless it is necessary for other reasons, such as other income earned).
- Use your records to offset the 1099 received at redemption.
How to make the §454 election to be taxed via accrual method
There is no formal instruction for this, the guidance simply states that you would make this election by filing a statement with the tax return (of the child). Therefore, you would need to file a tax return in the initial year, but in subsequent years a tax filing is only necessary if total income exceeds the threshold for Kiddie Tax filing. Suggested wording could be:
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 the above to PDF and attach to the e-file return of the child.
This sounds great, but I wish I had heard about it 3 years ago when I bought the bonds!
It isn't too late. You can elect into the Accrual method at any time. When you do that you would have to recognize all income accrued thus far. Using the same example numbers above, but 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. This would be 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:
- Child Standard Deduction ($1,250 in 2023).
- Child Tax Bracket (another $1,250 in 2023).
This means that if a child has unearned income of $1,250 or less, there is no tax and no filing requirement for the child. The exceptions being if there is earned income or if there are capital gain transactions. If the child has unearned income of more than $1,250 but less than $2,500, then they are taxed at the child's tax rate. In our example above, $1,576 results in $33 of tax because:
- $1,576 Unearned income.
- $1,250 Standard deduction.
- $326 Taxable income.
- $33 tax at 10% (the child's rate).
Whereas, if the total unearned income was above $2,500, things would be more complicated as the child would then need to use the marginal tax bracket of their parent when calculating the tax due.
What if there is other Kiddie Tax Income?
The reason this strategy works is that each annual payment, even in year 15 where it earns $989.97 is under the standard deduction of $1,250 (which tends to increase annually for inflation). If the child had some other unearned income, then 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 is under the $1,250 limit (and perhaps even if it is above it) it could be still worth doing. But if the income is substantial in these years, it might be better to defer the recognition of gain until the future.
Opting in to annual taxation can be a good option in certain situations, this is most often found with children. It should be noted that these would be a countable asset for student aid, which is why the child might want to redeem them before they mature. At that time it is possible that they could 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 do not 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.
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