I-Bonds, you will recall, are US Savings Bonds that protect you from inflation and grow deferred from taxes. Currently, they yield 6.49%. They will not make you rich, but they’re completely safe.
Death, you will recall, is currently a way to escape the capital gains tax. Your heirs have the option of ‘stepping up the basis’ of the stuff you leave them to its current value when you die.
This applies to real estate, jewelry, and just about anything else, but most commonly to stocks. Say Gramps bought 100 shares of Johnson & Johnson at $28 and when he died, it was $80. You inherit those shares and, a while later, sell them at $90. Your taxable gain, if you elected the step-up in basis, is just $10 a share. Sell at $65 and – far from having to pay tax on the gain – you get to take a $15 a share loss.
Much is made of people jumping out of windows when the market crashes. Tax-wise, it would be far more advantageous to defenestrate at the peak.
OK, that’s a bit extreme. But people do, understandably, look for every tax advantage, which is why it has rankled some of you that with Savings Bonds (as opposed to ordinary corporate or government bonds), heirs get no such step up.
(If at any point in this column you get bored, click here for something completely different.)
Diane Anderson: ‘Could you deal with the lack of a step-up by having the I-Bonds owned by a trust instead of directly by the mother-in-law? Then, the bonds wouldn’t get the step-up, but they still wouldn’t be taxable until the end of the 30-year term (because they’re not being transferred or retitled at the grantor’s death).’
☞ Why bother? Savings Bond owners, and their beneficiaries, may already elect to defer tax on the interest until the bonds are redeemed.
Jerry Avillion: ‘Regarding the non-stepping up of I-bonds at death, would you be able to avoid that by buying shares in Vanguard’s inflation protected securities fund?’
☞ Nope. If the shares were held in a taxable account, you’d be paying income taxes annually on the growth in principal value already. Yes, your basis would step up every year — but that is because the income was being taxed each year. If it were held in a tax-deferred account, all distributions would be taxed upon withdrawal by the owner or beneficiary.
CAPITAL GAINS TAX ON TAX-FREE BONDS
While we’re at it, maybe this is a good time to explain a couple of quirks about how taxes work on bonds. The interest is ordinarily taxed as ‘ordinary income,’ just like interest from a savings account or any other kind. The interest from a tax-free municipal bond is free of federal income tax (and free of state income tax if it was issued in your state).
But what of the difference in price between what you paid for a bond and what you sold it for (or the $1,000 it was redeemed for at maturity)?
Most bonds are issued at $1,000 face value and are redeemed for $1,000 years later, so if you buy at the beginning and hold the whole time, there is no capital gain or less, just all those years of interest income.
- What if you buy the bond in the open market for $800 and later sell it for $950? You owe capital gains tax on the gain – even if it was a tax-free municipal bond.
- (If you die and leave these bonds to your heirs, they could elect to step-up the cost basis to the value of the bonds at the date of death.)
- What if the bond were Originally Issued at a Discount (an OID bond), like a zero coupon bond that pays no interest, but gradually rises in value from the price at which it was issued — $300, say – to $1,000 at maturity? In that case, there will be an ‘accretion schedule’ built into the bond, showing how much the bond ‘should’ appreciate each year in its inevitable climb to $1,000 at maturity. That accretion is considered interest, not a capital gain. Only to the extent your gain when you sell exceeds that expected accretion do you have a taxable capital gain. To the extent it falls short of the expected accretion schedule, you have a capital loss. It is obviously the stuff of migraines – and reason enough not to buy such bonds, except within a tax-deferred retirement account where it doesn’t matter.
And now – unless you got bored and already clicked it up above – a little fun from Newt Gingrich pal, columnist Arianna Huffington (who is my pal, as well). Click here.
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Wealth is not his that has it, but his that enjoys it.~Ben Franklin
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