Question: A friend told us that we can use savings bonds to accumulate money for our child's college costs without paying tax on the interest. We don't quite understand this - can you explain?
Answer: Your friend is right: here's how it works. You buy Series E bonds in the child's name, using the child's social security number. (You can name yourself as beneficiary, but if you are listed as co-owner, the interest will be income to you, not to the child.)
File a tax for the child for the first year after purchase, on which you report the interest accrued to date; write on the tax form: "Election to report Series E interest annually." Then it isn't necessary to file another tax return for the child unless he or she has gross income, including the bond interest, which exceeds the anual filing minimum ($750 for 1976).
When the child is ready for college, you can cash in as many bonds as you wish each year. Only the interest accured in the redemption year is subject to tax: and again there will be no tax or filing liability inless the child's gross income exceeds the minimum requirement.
This tax-saving technique is not limited to savings bonds. You can do the same thing with a savings account (passbook or certificate of deposit) at a bank, savings and loan association, or credit union; or with stocks, bonds, or a mutual funds, using a custodial account under the Uniform Gifts to Minors Act.
Q. Is insurance money subject to estate taxes? Does a beneficiary have to pay income tax on such money?
A: The proceds of an insurance policy on the life of the deceased is generally required to be included in the federal estate tax return if the policy was owned by the deceased.
But if the deceased had previously given up all "incidents of ownership" - that is, all rights normally available, such as the right to change beneficiaries - then the policy itself is not an asset of the estate at the time of death, and the proceeds would not be included.
There are risks and restrictions associated with such a gift. Be sure to discuss it fully with your insurance agence, attorney, and/or financial counselor if you contemplate such a step.
Some states - Virgina, for example - exclude from the taxable estate (for state inheritance tax purpose) the proceds of insurance payable to a named beneficiary, but require the inclusion of proceeds payable to the estate itself.
To answer your second question: Insurance proceeds are not subject to income tax if received in a lump sum. But if the beneficiary receives installment payments over a period of time, a part of each payment represents interest income.
The amount that is excludable as a return of a part of the principal proceeds is calculated in one of several ways, depending on the terms of the annuity payments. IRS Publication 559, available free at most IRS offices, explains how to make the computation for each of contract.