And the Winner of the Dumbest Tax Policy Initiative of the 21st Century Is...

By Sheldon H. Laskin, Adjunct Professor, University of Baltimore Graduate Tax Program

As Jon Stewart would say, I'm calling it right now.

Recently, a relative got a letter from the Treasury advising her that she might be the owner of fully matured US savings bonds and that federal income tax is due on the earlier of redemption or maturity.  This in fact has always been the law, but as a practical matter the tax is universally paid on redemption for the simple reason that until a 1099 is issued, no one - not the IRS, not the banks (who are not the payers of the interest but simply function as agents of the government on redemption and have no records of what bonds are in their safe deposit boxes) and not even the owner - has the faintest idea what the income on the bond is.

 According to the May 2001 issue of the Bond Teller (http://www.treasurydirect.gov/instit/savbond/guide/bondtell/bondtell_0501.pdf), the Treasury launched an outreach initiative in the Fall of 2000 "for holders of some 20 million matured savings bonds worth $8 billion" to have them redeem the bonds and pay the tax due on the interest income.  The letter is apparently a current manifestation of that initiative.

Whatever eager Treasury bureaucrat thought of the bright idea to send this letter just did not have his thinking cap on.   The current national debt is more than $15.25 trillion dollars.  If these twenty million bond holders were to redeem their bonds, the Treasury will be obligated to pay $8 billion dollars in principal and  billions more in accrued interest  (at rates often much higher than current rates), in return for maybe  hundreds of millions of dollars in tax.  And since the bonds are no longer accruing interest, if the owners hold onto them the result would be a huge cost-free loan to the government going forward.  And in a fair number of cases, the bonds will never be redeemed (does the US government pay gift tax?)

The Bond Teller article urges bondholders to redeem the bonds because "there is no advantage to holding onto bonds that no longer earn interest."  But this is not universally true.  It sometimes makes sense for the owner to hold onto the bonds, notwithstanding the lack of interest.   In some cases, redeeming them could push the owner into a higher tax bracket.   Bond owners tend to prefer holding their assets in cash, and in the current environment interest on cash investments is essentially zero anyway.  So if the owner doesn't need the income, it makes more sense to just hold the bonds and let the estate deal with the tax.

Perhaps sensing that the Treasury would actually lose money if this initiative were successful, the Bond Teller article attempts to justify the effort on economic stimulus grounds.  Commissioner of the Bureau of the Public Debt Van Zeck is quoted in the article as urging bond owners to "put their money back to work."  But even this justification doesn't hold water.  The kinds of people who hold substantial amounts of US savings bonds aren't likely to invest in REITs, derivatives or stock swaps.  If they couldn't hold these bonds, they'd put them in CDs or just stuff the cash under the mattress.

So the Treasury need not wait for the century to mature to redeem its award for the Dumbest Tax Initiative of the Century.  Congratulations, Treasury, and be careful what you wish for.

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