A key lesson within EVERY tax surprise
What follows is a true story. A story with a sad ending. But one that has a lesson for everyone. Stick with the story, with a high degree of certainty most tax surprises can be identified with a little help.
Background. Back in the 1970s, U.S. Savings Bonds were a popular savings alternative. Grandparents purchased them for kid’s college. Many used them to build funds for retirement. Even better, you paid ½ the face value, and later (usually 20 years) the bonds matured at twice what you paid for them. So a $1,000 investment yielded $2,000 when it reached maturity.
Our ingredients. In our case, this tax bomb had the following ingredients:
- Converted old Series E savings bonds with deferred interest;
- Series HH savings bonds with annual taxable interest;
- Owning uncashed savings bonds that no longer earn interest;
- Little help from the bank; and
- Confusing information from federal tax authorities about impending tax obligations.
The bomb is set
Joe purchased Series E saving bonds each year in the 1970s. With half down and promise of double value upon maturity, Joe amassed a nice $140,000 retirement fund. After 20 years the bonds matured. Joe did not yet need the money, so he converted them to Series H savings bonds. This effectively deferred the interest income on the old, Series E, bonds since the bonds were not cashed.
With the new Series H savings bonds, Joe paid federal income tax on the interest earned each year. Meanwhile, the taxable interest from the series E bonds continued to be deferred.
The result? Joe thought he was paying tax on the interest each year…BUT there was a sleeping tax bill on the interest of $70,000 just waiting until Joe cashed in his series H bonds!
The bomb explodes
Joe received word that his series H bonds would no longer pay interest. So he tells his grandson to go to a bank and cash in the bonds. Heck, why have bonds that no longer pay interest? And…it’s no big tax deal because he has been paying tax on his Series H bond interest each year. The grandson has financial power of attorney so he does as his grandfather asks.
Surprise! He receives a notice from the IRS saying he owes them $24,000! This includes plenty of penalties and taxes.
Lessons for all of us
- Never disregard 1099s or printed details. When the grandson cashed the bonds, if he looked closely on the face of the bonds, he may have noticed the deferred interest. But it would contradict what grandpa had told him. Further, his grandpa probably received a Form 1099 that was disregarded because he believed he was already paying the tax.
- Old savings bonds can be confusing. There are many different issues and flavors of savings bonds. When you see any uncashed bonds, conduct the necessary research to understand your potential obligations. This is especially true for bonds past their maturity date.
- Ask before you sell. Always understand the tax consequences BEFORE you sell any property. Even the most innocent of transactions can have their own tax time bomb. So call an expert before you buy or sell.
- Tax planning matters. While Joe would always owe federal income tax when he cashed the bonds, he could have reduced his effective tax rate by cashing them over time instead of all in one year. In this case, it exposed a lot of income to a much higher tax rate. He could have saved over $10,000 in tax with a little planning!
Because neither the bank nor federal taxing authorities believe it is part of their duty to help you make knowledgeable tax decisions, you are on your own. This one-way street of knowledge makes having an expert on your side more important than ever!