Gyroscopic Investing

After looking through the agreements for EE and I bonds, it looks like you can either pay the tax on the interest each year or you can defer it until after the bond matures or you sell it.

Does anyone have any thoughts on which of these would produce less of a tax hit over time?

If I pay for the tax every year, I'll benefit from being in lower tax brackets since I'm at the start of my career (25% until Bush Tax cuts expire at least) in the beginning versus if I pay all the tax out of the tax bracket I'll be in when I sell it (potentially during my peek earning years/highest tax bracket for me).

On the other hand, by letting the money stay in there instead and growing tax-deferred, it could build up higher versus the addition of having some years at lower taxes.

Presumably the second option of paying all of the tax when the bond matures/when I sell it would be the better bet from a tax perspective but not sure if there are times when this isn't the case.

Absent specific knowledge about your future tax rates (i.e., you know your tax rates will be higher at redemption) it is almost always better to defer paying taxes if you can.

If you are buying I/EE bonds in your twenties, the point about facing possibly higher rates in your peak earning years almost qualifies as specific knowledge, though.  Someone in that situation might want to consider the pay-as-you-go option. 

I will be about 80 when my oldest I-Bond matures, so I'm not too worried about being in a higher tax bracket.  Unless I have the good fortune to have very high RMDs

It is my understanding that this can not be done on a bond by bond basis.  I may be wrong, but I believe if you choose to use accrual basis accounting for one bond, then you have to for all of them.  One case you might want to do this is for children (where the biond is owned in their name).  Children (under age 14) that have less than $ 950 in unearned income do not have to file a return and pay no tax.  In cases where a child has under $ 950 in unearned income and some of it is accrued interest from EE bonds, then it would make sense to use the accrued interest method and file a return (even though there is no tax).  This would avoid taxes  instead of waiting to cash the bonds in to report the interest.  Because of this feature of EE bonds, and the fact that you can decide when you can cash them in, EE bonds used to be a pretty good tax planning tool.  I say used to be, as they used to have a good yield, especially if held long term. 
Norm

WildAboutHarry wrote: Absent specific knowledge about your future tax rates (i.e., you know your tax rates will be higher at redemption) it is almost always better to defer paying taxes if you can.

If you are buying I/EE bonds in your twenties, the point about facing possibly higher rates in your peak earning years almost qualifies as specific knowledge, though.  Someone in that situation might want to consider the pay-as-you-go option. 

I will be about 80 when my oldest I-Bond matures, so I'm not too worried about being in a higher tax bracket.  Unless I have the good fortune to have very high RMDs

ngcpa and WaH,

Thanks for the replies. That is the conundrum though. I'm 24 right now and If I hold EE or I bonds to maturity (either the 20 or 30 year mark), I'm almost 100% positive that I would be in a higher tax bracket by the time I would be redeeming them. I guess I don't know where the break even point is of hypothetically I was in the 25% tax rate for 7-8 years and then got into the 28% bracket after that (or whatever the equivalents will be after Bush Tax cuts expire). I'm wondering where the break even point is if you said you pay tax every year but the first 7-8 years you pay a lower tax by a few percentage points.

Also regarding ngcpa, I'll have to check if however you could state at the beginning of the bond that you want to have these ones as an accrual or not. If you couldn't, then you could never change your taxing technique as your life variables are changing (unless you let all of your bonds mature). That makes me wonder whether it is just easier to do cash basis then.

Ngcpa is right about the all-or-nothing aspect.

TreasuryDirect wrote:Cash Basis Reporting-federal tax is deferred until the year of final maturity, redemption, or other taxable disposition, whichever is earlier.
Accrual Basis Reporting-you report interest annually each year as it accrues. Once you start, you must continue to report interest earned annually for all savings bonds and notes you own and any you may acquire. This may be advantageous for EE/E Bonds in a child's name.

I've always deferred taxes on I-Bonds, but obviously I didn't start buying them in my 20s (of course they weren't available way back then either).

If I was in my twenties and planned on making I/EE bond purchases throughout my investing life I'd defer the taxes.

WildAboutHarry wrote: Ngcpa is right about the all-or-nothing aspect.

TreasuryDirect wrote:Cash Basis Reporting-federal tax is deferred until the year of final maturity, redemption, or other taxable disposition, whichever is earlier.
Accrual Basis Reporting-you report interest annually each year as it accrues. Once you start, you must continue to report interest earned annually for all savings bonds and notes you own and any you may acquire. This may be advantageous for EE/E Bonds in a child's name.

I've always deferred taxes on I-Bonds, but obviously I didn't start buying them in my 20s (of course they weren't available way back then either).

If I was in my twenties and planned on making I/EE bond purchases throughout my investing life I'd defer the taxes.

That's kinda my thinking to do Cash Basis Reporting since I'll be setting up EE/I-Bond ladders throughout my lifetime (assuming they are still around). My first bonds when I'm in my 20s might not make sense to have as Cash Basis but if I continue purchasing new bonds when I'm in my 30s and 40s, they'll mature after I'm old and crusty and in a lower (hopefully taxes don't explode upwards) tax rate.

Your approach seems likely to be optimal, all things considered.

The only wrinkle for the future is how often the treasury mucks around with the savings bond program.  But it has been a great ride so far.

Well as long as the rules wouldn't be applied retroactively, then we might not have to worry hopefully too much about that wrinkle. If EE/I-Bonds change however then they might either be a better or worse investment opportunity. As long as the old rules apply for the old bonds I wouldn't think that'd be too bad for the cash basis reporting still.