Tom Talks Taxes - June 17, 2022
Tax aspects of inflation investments: TIPS and Series I savings bonds
The United States is in a period of high inflation: in May 2022, the annual inflation rate was 8.6%. Stocks are also volatile; as the Federal Reserve continues to raise interest rates, we will likely see a downward trend in the stock market.
The federal government offers two safe investments that provide built-in inflation protection:
Individual investors can buy these bonds directly via TreasuryDirect.
Before I discuss the particulars of each bond, there is one significant tax benefit they share: the income earned is exempt from state and local income tax. The bond itself is not exempt from state inheritance or estate taxes.
Treasury Inflation-Protected Securities. TIPS have terms of either five, 10, or 30 years. They earn income in two ways:
Interest is paid every six months (the rate is fixed upon purchase), and
The principal is adjusted regularly for inflation (it can increase or decrease).
The interest paid each year on the bond principal is taxable. This income is reported on Form 1099-INT, Interest Income.
The inflation adjustment to the bond principal is taxable in the year accrued, even though the taxpayer does not receive payment of that amount. This income is reported on Form 1099-OID, Original Issue Discount. See Treas. Reg. §1.1275-7(b).
Due to the annual taxation of the inflation adjustment, it is best to invest in TIPS in a tax-deferred account, such as a traditional IRA.
Series I Savings Bonds. I’m not going to lie: I’m a fan of I bonds. I want to share why I am a fan and how they have a better tax profile than TIPS.
The I bond is a 30-year federal savings bond. Each calendar year, taxpayers are limited to $10,000 in I bond purchases. A taxpayer can get a paper I bond via a federal tax refund purchase or an electronic I bond via TreasuryDirect purchase.
I bond interest is compounded semiannually and adjusted every six months based on the inflation rate. An I bond cannot be redeemed in the first year, and if it is redeemed within five years of purchase, the taxpayer forfeits the last three months of interest.
I bonds purchased between May 1, 2022 and November 1, 2022 have an initial annual interest rate of 9.62% for the first six months. Unless there is a significant economic change, the next six-month rate will likely be high, meaning the first year will have considerable interest accruals. Higher interest rates in the first few years of the I bond’s life lead to more significant compounding potential over the bond's entire life.
For cash method taxpayers, interest accrued on an I bond is tax-deferred until the tax year in which:
The taxpayer cashes the bond and receives the principal and interest,
The taxpayer gives up ownership of the bond, and the bond is reissued, or
The bond stops earning interest because it has reached final maturity.
A taxpayer can elect to include savings bond interest ratably as it is earned; however, that election applies to that savings bond and all future savings bonds purchased. This election is made by reporting accrued interest on the taxpayer’s tax return. See §454(a) and Treas. Reg. §1.451-1(a)(1), (2).
Permission to change back to the original method of deferring savings bond income is granted automatically if the taxpayer files a statement to a timely filed tax return that meets the requirements of Rev. Proc. 2018-31, Sec. 17.
Since the I bond is a federal savings bond, interest earned upon bond redemption is excluded from tax under §135 if the taxpayer pays qualified higher education expenses during the same tax year. The qualified expenses can be for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent.
In tax year 2021, the exclusion begins to phase out at modified adjusted gross income of $83,200 or $124,800 on a joint return. In addition, the taxpayer had to be age 24 or older when the bond was issued, and the exclusion is not available on a married filing separate return. See Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989.
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You can purchase up to $10K of the I-bonds on-line and get an additional $5k as a tax return for a total of $15K per year or $25K per year per couple. Nothing says you can't make an estimated payment just before the tax filing just to get a refund back as an I-bond.