Savings Bonds – Child Ownership

The earnings on investments or savings owned by a child who is under 14 years of age are tax exempt if the earnings are under $750 each year. A 15% tax rate is levied on the next $750 of earnings, and any earnings above $1,400 are taxed at the parents’ highest rate, known as the “kiddie tax.”

Because of this $750 per year tax exemption rule, a portfolio of U.S. Savings Bonds in a child’s name can be beneficial. If the interest on the savings bonds is reported annually instead of deferring the taxes until the bonds mature, taxes may even be avoided. This is due to the fact that interest payment on new bonds is small at first (under $750). Also, a child can own many bonds and still keep the yearly interest limit for tax-exempt status under the $750 limit.

To report annual interest for a child’s savings bonds, file a tax return in the child’s name for the first year of ownership, and show the amount of interest earned. Interest can be calculated by subtracting the value of the bond when purchased from the value at the end of the year. Taxes for the child will not have to be filed again until his/her income exceeds the $750 limit.

When your child’s interest income is larger than $1,400 and will be taxed at the parents’ rate, file Form 3120 ("Application for Change in Accounting Method”) with the IRS. This will then switch the method of reporting taxes from the annual method to the deferral method.

There is also the possibility of replacing older savings bonds owned by children with new, higher-yielding bonds. Some Series EE bonds issued between May 1, 1995 and April 30, 1997 earn less interest than Series I bonds earn. These Series EE bonds have not earned much overall interest, and it is possible to exchange the EE bonds for the I bonds without having to file a return or pay tax on the transaction for bonds with a face value of up to $4,750.

“Swapping” savings bonds does save money. Deferred taxes on a bond owned by a child will have to be paid some day. However, when comparing the after-tax results, older bonds pay less than the swapped bonds.

For example, ten Series EE bonds purchased at $100 each in October 1986 earning 3.99% is worth about $1,250 today. If the bonds are held for another year, and a 15% Federal tax is issued on them, the bonds will be worth $1178. If the bond is “swapped” for a Series I bond paying 5.92% a year, the value after a year will be $1,203; however, after Federal taxes are paid, it will be worth $1190.

It is essential to remember that if you cash in the bond at the wrong time, it is possible to lose up to six months of interest. Therefore, when swapping a bond, always do it in a month when the older bond accrues interest.

In summary, it is worth looking into purchasing Savings Bonds for your children or grandchildren, but the benefits come when you are cognizant of the tax implications, the methods of filing taxes on them, and considerations for replacing the bonds.