Should we cash in our bonds and pay the tax?
Several years ago, my wife and I inherited several “I bonds” and they are now past their maturity date. Would it be a good idea to cash in these bonds today and pay the tax (we are in a 25% tax bracket)? We have no immediate use for the money right now, so we would probably put it in our savings account. Right now, the savings account pays very little, so is this a lose-lose situation? By that I mean, will we pay a tax on the bond, earn interest, and get very little interest on our savings in the future?
You will pay tax on the interest the bond earned, but an option is to invest the proceeds in a mutual fund or exchange traded fund that will earn you more return on the proceeds than your savings account. You can even buy a fund that invests in treasuries. It should get you more of a return than your savings account. It will throw off taxable interest, but that means it made money. Don't let the tax tail wag the dog. If you pay tax, it means in most cases you've made money and you have more money than you did.
This all depends on when the IBonds were originally issued. If they are over 30 years old, then they pay no interest anymore. Therefore, it is dead money and you need to redeem, pay the taxes, and move on. Otherwise, you are simply giving the government an interest free loan and it is paying you even less than your savings or zero. Even if they are still paying interest, you need to determine the interest rate they are paying to see whether they are worth holding or not.
The good news is that either way, it is a windfall even after paying the tax. Now if the proceeds are used for tuition and/or secondary education, you may be able to avoid all or part of the taxes on the interest. I have attached a PDF directly from the Treasury to help you see all of the rules.
With regard to what you should do with the money, that all depends your other assets. So I feel uncomfortable giving you advice without knowing your asset allocation.
Best of luck, Dan Stewart CFA®
You have misunderstood how I-Bonds work. All I-bonds continue to pay interest for 30 years from their origination date and the first I-Bonds were issued on September 1, 1998, so even the earliest I-Bonds won't mature until September 1, 2028. Therefore, you can continue to hold your I-Bonds if you wish until 30 years from the origination date and they will continue to pay interest. If they are in the old-fashioned paper form, then you can go to Treasury Direct as my wife and I did with our I-Bonds and register them in modern electronic form. That also makes them much easier to redeem and to track, and there is no risk of theft or loss.
You should find out the exact dates of issue, because that will determine how much interest they pay. The amount of interest changes frequently but it is combination of the original base rate and a floating inflation rate. If the original base rate is high, as it had been for the first five years (1998 through 2003), then you will generally be getting a high rate of interest that you cannot get in modern times at any bank or anywhere else. In that case, you should keep your I-Bonds until maturity or at least until interest rates are much higher. Otherwise, you can redeem your I-Bonds. Here is the official U.S. government web site which states the exact rates of interest for all I-Bonds:
Whenever the I-Bonds are redeemed you will pay taxes on all accumulated interest. You only have to pay federal tax since--like all U.S. government bonds--I-Bonds are free of state and local taxes by federal law. You also have the option of paying taxes in advance on the accumulated interest so you will pay less upon maturity, but if you do that be sure to keep track of it since otherwise you might end up paying taxes a second time on the same interest which is a mistake that many people make.
The best approach is to pay interest during the years when you are in the lower federal tax brackets, so if your income varies a lot from year to year you should redeem these or pay accumulated interest in your low-income years. If you tend to be in the same tax bracket each year then simply redeem them upon maturity.
It makes no sense to sell the I-Bonds and put the money in a savings account which will pay less interest and which will be subject to state and local taxes. That is the least desirable plan and I would recommend changing it.
Not knowing your age or the approximate value of your I bonds, my suggestion is to go ahead and cash the bonds in. Use the Savings Bond Wizard available at Treasury Direct to calculate the interest earned on each bond. If you are concerned about taxation, you may want to cash some in now and some early next year. But please 'don't let the tax tail wag the dog.' Seek the advise of a tax professional if you are in doubt about your potential tax liability and your need to stagger redemption.
Rather than parking your money in a savings account, create a CD ladder with the money. Begin by purchasing CDs with short term maturities of 3 months to 2 years. Your local bank or credit union should be able to help you create the ladder.
Don't let our low interest environment paralyze you. If your bonds are no longer earning any interest, 1% is still 1% and more than 0%, even after taxes.
Keeping things in perspective, this is a good problem to have. But I do understand the concern. Keeping the funds in a savings account isn’t the only option. Depending on your risk tolerance and time horizon, you could reinvest the proceeds in something that has the potential to earn more than a savings account. However, if you are not comfortable taking on any risk, you would generally be limited to savings accounts and CDs. Even if you are considering short term bonds, proceed with caution. I wrote an article called Bond Fund Basics which goes into more detail. I hope you find it helpful.
Please note that this should not be considered investment advice and is only educational in nature.
Best of luck!
David N. Waldrop, CFP®