Tax Treatment of Series HH Bonds

QUESTION: My wife and I have some series HH Treasury bonds that are about to reach maturity. As we understand it, we will have to start paying taxes on them when they do mature. We want to continue to defer the taxes and are wondering whether we could put them into an IRA or Keogh for that purpose. We have consulted several banks, and none seems to know anything about this Treasury bond series.--S. E.

ANSWER: Savings bonds are purchased with after-tax money. So it would be foolish for you to put your savings bonds into a tax-deferred IRA or Keogh retirement fund. If you did, you would wind up being double-taxed on the principal amount you paid for the bonds, because all money in an IRA or Keogh is taxed when it is withdrawn--regardless of the original source of the money.

As you no doubt know, the interest you have been receiving twice a year from your HH bonds has to be reported on your federal income tax return for every year you receive the money. So you should have already paid the taxes on the interest you have actually received for the past 10 years--the life of HH bonds.

But if you traded in series E or EE savings bonds for your HH bonds, chances are you haven't paid federal taxes--savings bonds are exempt from state and local income and personal property taxes--on the difference between the amount you originally paid for the E or EE bonds and their redemption value. Holders of series E or EE bonds have the option to defer the federal tax on this increase in value--which represents interest--even after they exchange the bond for a HH variety, and most do. No tax on the appreciation of the EE bond is due until they are redeemed or reach final maturity.

When you cash in the bonds, the bank or other financial institution where you redeem them will file a form with the IRS telling the agency how much accrued interest you received, and you will be expected to report that untaxed sum as taxable income on your next federal income tax return.

Banks might be expected to be less familiar with series HH bonds than with the better-known series E and EE bonds, because HH bonds can't be purchased with cash. They are available only to holders of series E or EE bonds or savings notes who exchange these securities for HH bonds. Much more knowledgeable about these bonds are the Bureau of the Public Debt and the Federal Reserve Bank, which together handle the bulk of these exchanges.

Series HH bonds are 10-year, current-income securities issued at par in denominations of $500, $1,000 and $5,000. They are popular among investors who want a regular income, which they receive twice a year at an annual rate of 7.5% of the face value.

Series E and EE bonds, however, are appreciation-type securities purchased at a discount from face value. To buy a newer EE-type bond, for example, you pay half of the face value. A $100 bond will cost you $50. Over the 10-year life of the bond, you won't receive a single penny in interest, although it is accumulating at a rate of at least 7.5% a year compounded semiannually, provided you keep the bonds at least five years. You get your original principal plus the accumulated interest when you cash in the bond. That means you are guaranteed a little more than twice what you paid for the bond if you hold it for 10 years.

Series HH bonds may only be acquired by investors who have series EE or E bonds or U.S. Savings notes with a combined redemption value of at least $500. Holders of series EE bonds cannot make an exchange until they have held the bonds at least six months.

If you own series E or H bonds, the predecessors to EE and HH bonds, you may retain your bonds and continue to earn interest on them beyond the original 10-year life, thanks to extensions by Congress. Holders of E bonds issued 40 years or longer ago should have been alerted that their bonds have reached final maturity and they should either be cashed in or exchanged for HH bonds. By converting them rather than redeeming them, these holders can delay the tax bill for another 10 years. Be sure to act within a year of the final maturity date, because they no longer earn interest beyond that point.

Application forms and instructions for exchange of series E and EE bonds are available from banks and other financial institutions, Federal Reserve banks or branches and the Bureau of the Public Debt, whose mailing address is simply Washington, D.C. 20226.

Q: Your column on single-premium insured deposit policies brings to mind a question I've had for some time about the safety of investments with life insurance companies. Does anyone insure them as the FDIC does banks? And if not, how do you check out how healthy the insurance company is before you invest your money?--E. M. H.

A: There is no single agency that insures consumer investments in life insurance companies, as every consumer unfortunate enough to see his life insurer fail knows all too well. But 36 states have established insurance pools--funded by assessments from the insurance companies themselves--to protect consumer assets in life and health insurance companies in the event of a failure. California isn't among them.

California does have a property and liability insurance fund, called the California Insurance Guarantee Assn. But several efforts to establish a separate fund to help protect investors in life insurance have failed in the California Legislature and with California voters, presumably because of concerns that taxpayers would end up footing the bill. You can never be 100% sure that a company won't fail, no matter how healthy it seems on paper. California insurance regulators recall one failure of an insurance company that had been in operation for more than a century and had received consistently high ratings from an independent rating agency until just before the company collapsed.

But given that caveat, you might pay a visit to your local public library and look through the latest copy of Best's Insurance Reports, a thick book that evaluates the nation's insurance companies based on their latest year-end financial data. Keep in mind that the ratings could be as long as a year out of date since Best's comes out just once a year. But by comparing the company you're interested in to a few others, you can get an idea of how healthy the company is.

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