Friday, 15 January 2021

How Do Savings Bonds Work?

How Do Savings Bonds Work?
08 Jan
6:08

Updated on Friday, January 8, 2021

Savings bonds are a popular savings vehicle for conservative investors, as they are backed by the full faith and credit of the U.S. government. With savings bonds, you are paid a fixed interest rate on the principal paid for the bond.

Just like other savings vehicles, though, savings bonds have their own benefits and drawbacks. This article covers what you need to know about savings bonds to help you determine if they are right for you — from which types there are to how to buy them.

What are savings bonds?

Similar to municipal bonds, savings bonds are a way for the government to raise money for debt by promising to pay back principal and interest to bondholders at a later date. The government backs the repayment of the bonds, making them low risk for investors.

Savings bonds can be issued for face values as small as $50 and purchase amounts as low as $25.

How do savings bonds work?

Savings bonds work by paying a fixed interest rate on the principal paid for the bond. Depending on the type of savings bond you buy, you may be guaranteed to redeem the bond for double the amount paid.

There are three important features of savings bonds that you should know about before buying:

Savings bonds are usually tax-deferred: The interest earned on a savings bond (except for the Series HH bond) does not need to be reported as it’s earned, although taxpayers can report it annually if they wish. It is permissible to report the interest earned only when the savings bond is redeemed, at which time you will be issued a 1099-INT for tax reporting. If the savings bond isn’t redeemed by year 30, however, the earnings must be reported.

Savings bonds may be tax-exempt: Series EE and I savings bonds are not subject to state or local taxes. In addition, if savings bonds are used for certain qualified higher education expenses and you were at least 24 years old on the first day within the month the bonds were purchased, then the interest earned may be federally tax-exempt.

Survivorship: When purchasing a savings bond, the bondholder can name a survivor who will have the ability to cash in the bond or have the bond reissued once the bondholder passes away. When no survivor is named, or when the survivor passes away before the bondholder, the bond will generally become part of the deceased bondholder’s estate.

Which types of savings bonds are there?

Once you have decided to buy a savings bond, there are two types to choose from: Series EE and Series I.

  • Series EE Savings Bonds: Sold only electronically through treasurydirect.gov, Series EE bonds have a fixed rate of return. If not redeemed until year 20, bondholders will receive twice the purchase price of the bond.
  • Series I Savings Bonds: Unlike EE bonds, Series I bonds have both a fixed interest rate and an inflation rate, and they are not guaranteed to double in value by year 20. The inflation rate is calculated twice per year based on the consumer price index for all urban consumers (CPI-U). With this savings bond, the bond rate will change every six months. However, it does have a fixed rate component that stays fixed throughout the life of the bond, acting as a floor to protect against negative inflation.

There may be some individuals who have what’s called an HH bond, purchased before September 2004. In the past, these were issued in exchange for the no-longer-offered Series E bonds as well as Series EE bonds. Series HH bonds are no longer available for new purchases, but those who are still holding them can cash them in at their local bank.

While old Series E bonds would have passed their last interest-earning deadline, there may be some old HH bonds that are still earning interest, including the last issues from 1998, which will earn interest for a total of 20 years. If you think you may have one of these bonds but have lost the certificate, you can use Fiscal Service Form 1048 to reclaim it.

Where can you buy savings bonds?

Depending on the bond you want, there may be a few places you can buy savings bonds, such as on treasurydirect.gov, at your bank and through your tax return. However, savings bonds are not traded and there is no secondary market for them.

How to buy Series EE bonds: These bonds are only sold electronically (paper EE bonds are no longer distributed), and they can only be bought online. Purchasers can buy up to $10,000 in EE bonds each year.

How to buy Series I bonds: These bonds can be purchased in paper or electronically. In addition to buying them online, they may be bought at some banks, and taxpayers can choose to have their tax refund used to purchase them by using IRS Form 8888. You can buy up to $10,000 electronic I bonds per Social Security number per year and up to $5,000 in paper bonds through a tax refund.

How do you cash in savings bonds?

The way you redeem your savings bond will often depend on whether you have a paper bond or an electronic bond. In many cases, you can simply take a paper bond to your local bank to cash it in.

Electronic bonds, however, will generally be redeemed online through the treasury website. Note that the amount you’re redeeming may be an issue when it comes to electronic bonds, as there are minimum redemption amounts and minimum remaining balances required on partial redemptions.

“When you redeem a savings bond, it’s best to redeem earlier in the month,” said Ken Tumin, founder of DepositAccounts.com. “You’ll still get credit for the whole month.”

Note that neither EE nor I bonds can be cashed in within the first 12 months after purchase. If they are cashed in within five years of issuance, the final three months of interest is withheld. For example, if you cash in an EE or I bond 48 months after issue, you will receive only 45 months’ of interest.

Are savings bonds a good investment?

Like any investment or savings vehicle, there are both pros and cons associated with savings bonds, as outlined in the table below:

Pros and Cons of Savings Bonds

Pros

Cons

  • Generally a safe investment, as they offer protection of the principal
  • Can be a good way for young people to learn about investing
  • Typically have lower interest rates
  • Do not usually produce significant returns

Without looking at an individual’s entire portfolio, it’s impossible to say whether savings bonds are a good investment. They are a guaranteed investment, and a safe one, but their low interest rate might not be what every investor needs.

“The question is whether what you’re getting in rate of return keeps up with the rate of inflation,” said Alexander Lowry, executive director of the master of science in financial analysis program at Gordon College in Wenham, Mass. “There are different types of people savings bonds might be good for.”

One example that Lowry provided was giving a savings bond as a bar mitzvah gift to a young person who’s still learning about investing. But when it comes to someone in their 30s or in their peak earning years, Lowry suggests that savings bonds are not an ideal place to put all your money for the long term.

“People should focus on what their investing objective is. For example, is [your objective] the return on your investment or the return of your investment,” said Lowry. In other words, while they may not offer a significant return, savings bonds do offer protection of principal, which may be more important to some savers than the return they earn on their principal. Those who are more concerned about return might want to look at more aggressive investments.

Source: https://www.magnifymoney.com/blog/earning-interest/how-savings-bonds-work/

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