Q&A: Understanding bonds' interest, beneficial options

Q: My father, who is 88, sent a few HH bonds that he purchased in 1996 to Treasury Retail Securities Site in Minnesota. He got the principal/face value amount of these sent to him but we are confused about any interest that is due. The lower left hand corner of the bond stated that the deferred interest was $438.64. – Ken Idstein Waukegan, IL

A: The interest HH bonds earn each year is reported on a form IRS 1099-INT issued to the bondholder, says Jean-Luc Bourdon, a certified public accountant and personal financial specialist with BrightPath Wealth Planning, LLC. “That way, the interest gets included on the bondholder’s yearly federal income tax return,” he says. “The interest is not taxable for state income tax purposes."

Now, because your father paid tax on the interest he got from his HH bond each year, the amount of deferred interest listed on the bond is understandably confusing, says Bourdon.

According to Bourdon, here’s how it came about: When your father got his HH bond in 1996, they were only available in exchange for other bonds. If the bond(s) exchanged had deferred interest, that interest got included in the face amount of the HH bond. Because that interest was rolled into the HH bond and not paid to your father, federal income tax on that deferred interest was postponed.

Now that your father cashed in the HH bond, the form IRS 1099-INT he gets this coming January will include the $438.64 of deferred interest listed on the bond, says Bourdon.

You can find more details at https://www.treasurydirect.gov/indiv/research/indepth/hhbonds/res_hhbonds_hhtaxconsider.htm

Q: I purchased I bonds in 2000 and 2001 yielding around 5% and plan to hold them as long as possible based on the 30 years I have available. My wife and I are 65 [and retired] with infant grandchildren. Is there any way I can use these for their college needs and avoid the taxation at that time on the interest earned? The I bonds were issued one-half to me (with my wife as beneficiary) and one-half to her (with me as beneficiary). – Steven Steinberg, Buffalo Grove, IL

A: For the Series I bonds or Series EE bonds to qualify for the interest exclusion of the Education Savings Bond program, they must be used to cover the educational expenses of the taxpayer, taxpayer’s spouse or taxpayer’s dependent within the meaning of IRS Code Section 151, says Stephen Allen, a personal financial specialist with Reitz & Allen CPAs,

“Since your intent is for the funds to be used for the education of your infant grandchildren, who I would assume are not your dependents, it would not qualify for the interest earned exclusion,” says Allen, who is also a member of the AICPA’s PFP Executive Committee.

An additional provision for it to meet the qualification, says Allen, is the bonds have to be issued after 1989 to an individual that is at least 24 years old before the bond’s issue date.

“You could possible look into transferring ownership of record for the series I bonds to his children, but the date provision above could limit this possibility,” says Allen. “If they were over age 24 when the bonds were issued, they could list the grandchildren as beneficiary.  But this change process would entail much more clarity on the facts and extremely careful planning to facilitate such a change.”

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch. Got questions about money? Email rpowell@allthingsretirement.com.