Bond holders losing means to defer taxes
By Laura Bruce • Bankrate.com

Some savings bond aficionados will have to move fast to avoid paying tax on interest income accumulated over the years. The HH bond is going the way of Ford's Edsel after Aug. 31.

The HH has long been used by savers to reinvest funds from maturing E/EE bonds, and to continue deferring taxes on accrued interest for up to another 20 years. But the government says high transaction costs and poor sales have doomed the HH.

Ironically, investors now scrambling for a way to dodge the tax hit are scooping up the bonds, says Steve Meyerhardt of the U.S. Treasury's Bureau of Public Debt.

"There's been what would be in HH bond terms a rush by people to get in before they're gone."

Deciding whether to reinvest in HH bonds may not be easy since they're paying a discouraging 1.5 percent. Buy now and that's the rate you'll get for the first 10 years you own the bond. The rate may be adjusted during the second half of the bond's life.

The main reasons to exchange expiring E/EE bonds for HH would be to avoid realizing significant income that could cost you heavily in taxes, or that could boost your adjusted gross income into a higher tax bracket where you'll lose other tax breaks.

If you haven't accumulated much interest in a soon-to-mature E/EE bond, switching to an HH may not be worthwhile. But if you have accumulated a significant sum of interest over the years in an E or EE bond, deferring taxes may be more important to you than the paltry 1.5 percent interest rate.

"Even if you're not planning to hold the HH for the full 20 years, if you make the exchange now you can cash them in over the next three or four years and minimize your tax risk," says William Massey, senior tax analyst at RIA, a provider of tax information and software to tax professionals.

Besides paying hefty taxes, Massey cautions that realizing all that income at once could push you into a higher tax bracket and cause you to pay higher Social Security taxes, lose the medical-expense deduction or cause qualified dividends and capital gains to be taxed at 15 percent vs. 5 percent.

Dan Pederson, president of the Savings Bond Informer, a savings bond consulting service, says that everyone's situation is unique, but that most investors will be better off staying with their current bonds if they have more than five years left before maturity.

"If you bought one in 1992, you still have 18 years left of life on that bond, and you're not gaining much tax deferral by going to the HH. The HH is only paying 1.5 percent; most E and EE bonds range from 2.5 percent to 6 percent, with most paying about 4 percent. You'd give up 2.5 percent a year to get the HH and you're not gaining anything in the deferral."

To exchange an E/EE bond for an HH, the E series bond must be at least 12 months old and be worth at least $500. The U.S. Treasury's Bureau of the Public Debt has guidelines for making the exchange.

If exchanging for an HH bond doesn't appeal to you and you opt for cashing out when the E/EE matures, you'll have to settle the tax bill and look for another investment vehicle.

Certified financial planner Barry Vosler of LPL Financial in DeWitt, Iowa, suggests a fixed annuity may be a way to go for someone who would like to defer taxes. Vosler says a five-year annuity should pay about 4.25 percent. It would be similar to a bank CD, but with the tax-deferral benefit. Be aware that generally you'll pay an IRS penalty if you withdraw the money before age 59 1/2, and you may pay a surrender fee to the insurance company if you withdraw money before a stipulated amount of time. Also, annuity income generally is taxed as ordinary income as opposed to long-term capital gains.