U.S. SAVINGS BONDS are sold in two forms: EE bonds and I bonds. The U.S. Treasury Department issues them and markets them as a patriotic and profitable investment for the so-called little guy. Not surprisingly, they're the most widely held security in the world. The paper version of the series EE savings bond is named the Patriot Bond.
Although U.S. savings bonds have the reputation of being simple and straightforward, nothing could be further from the truth. Therefore, we start this chapter with the following warning: the structure of savings bonds is not only complex but has changed many times over the years. For example, the calculation of the yield on EE bonds has changed four times since 1990. Until May 2005, you could not predict what your return would be on EE savings bonds because it had a floating rate. I bonds still have a floating rate. Their tax consequences are even more complex. The way you register ownership of savings bonds has important tax consequences.
Because of these complexities, we describe the best way to capitalize on the advantages of the EE and I savings bonds under each individual description. Despite their complexity, savings bonds may be great investments. There are no fees, loads, or commissions to buy them. They are fully guaranteed by the U.S. government, will not decline in value over the years, and are not callable. They are free of state and local income tax and may be free of federal income tax if used for certain educational expenses by qualified taxpayers.
All savings bonds are nonmarketable, which means that you cannot sell them to anyone other than a paying agent authorized by the Treasury Department. You may not use them as collateral for a loan. However, after you own them for a minimum of twelve months, you can sell (redeem) your savings bonds back to the Treasury Department at any time. You simply take them to your financial institution with proper identification, and you'll be assisted through the redemption process. However, if you redeem your EE or I savings bond earlier than five years from the issue date, you must pay an early redemption penalty equal to the last three months of earned interest.
You can buy EE and I savings bonds in two ways: You can buy and hold savings bonds in electronic form in a direct electronic account with the Treasury Department at TreasuryDirect. Go to www.TreasuryDirect.gov. This Web site is an excellent source of information on all savings bonds. Alternatively, you can buy paper savings bonds at any of the approximately 40,000 financial institutions that the Treasury Department authorizes as issuing and paying agents.
You must choose one of three ways to register savings bonds:
Single ownership. With single ownership registration, only the registered owner, such as "John Doe," can cash or make a gift of the bond. On John Doe's death, the bond will become part of his estate and will go through probate.
Co-ownership. With co-ownership registration, such as "John Doe or Robert Smith," either co-owner may cash the bond without the knowledge or approval of the other. When the first co-owner dies, the second becomes the sole owner of the bond. This is similar to a joint account at a bank and avoids probate. You should determine whether there may be gift tax consequence of registering a bond in the name of someone who has not provided the cash to purchase the bond.
Beneficiary. With beneficiary registration, such as "John Doe, payable on death to Mary Doe," only the owner, John Doe in this case, may cash the bond. The beneficiary, Mary Doe, if she survives John, automatically becomes the sole owner of the bond when John dies. This type of ownership avoids probate, unless Mary predeceases John.
If you own paper EE or I savings bonds, you can trade them in for electronic bonds at TreasuryDirect, using a program called SmartExchange.
The TreasuryDirect Web site, www.TreasuryDirect.gov, has a description of the rules relating to all the EE savings bonds issued to date. Different rules apply depending upon what date you purchased your EE bonds. The description that follows applies only to EE bonds sold (a) between May 1997 and April 2005 (called here "old EE bonds") and (b) EE bonds sold beginning May 2005 (called here "EE bonds").
Interest on EE bonds purchased on or after May 1, 2005, accrues monthly and is compounded semiannually. However, no cash is paid out until the bonds are redeemed. EE bonds stop earning interest thirty years from their issue date.
A fixed interest rate for EE bonds is announced for new issues each May 1 and November 1. The fixed rates have ranged from a low of 3.2 percent to a high of 3.7 percent from May 2005 to April 2007, depending on the date that the EE bonds were purchased.
EE bonds earn a rate of return that is fixed at the date of purchase for the first twenty years of the bond, and this rate will be extended automatically for ten more years unless the Treasury announces different terms for the final ten-year period. Thus, you can calculate what the EE bonds will be worth for their first twenty years. You can buy EE bonds either electronically or as paper EE bonds.
If you buy your EE bonds electronically, they go to your designated account at TreasuryDirect. You can buy these electronic bonds at face value in any amount for $25 or more. Any individual can purchase a maximum of $30,000 in any one calendar year. Thus, you and your spouse can each buy $30,000 of EE bonds per year. (See "Recommendations and Tips" under I bonds for a way to buy more EE bonds than $30,000 if you're married.)
If you buy paper EE bonds, they are issued as paper bond certificates, and you can buy them at half their face value. For example, you pay $25 for a $50 bond, but it won't be worth its face value of $50 until it matures. You can buy the paper EE bonds in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000.
Old EE bonds, those purchased between May 1997 and April 30, 2005, earn a variable rate of return that is set at 90 percent of the average yield on 5-year Treasury securities for the preceding six months. The interest rate on old EE bonds changes every May 1 and November 1. If you own old EE bonds, you never know what long-term return you will get. These bonds do, however, provide two very important guarantees: (1) they reach their face value in a maximum of seventeen years, and (2) they will not yield less than 4.2 percent for that seventeen-year period. Thus, no matter how low the 90 percent average falls, holders of old EE bonds are guaranteed a minimum 4.2 percent compounded interest rate of return at the end of seventeen years. Should the 90 percent average turn out to be greater than 4.2 percent, the holders of old EE bonds will benefit by receiving a correspondingly greater return than 4.2 percent. Between May 1997 and May 2002, for example, the six-month returns on old EE bonds varied from a low of 3.96 percent to a high of 5.68 percent. Each time the interest is added, the redemption value of the bond increases.
EE bonds have numerous attractions. Most important, they provide protection against inflation and deflation, plus a guaranteed lump-sum distribution at any time after you hold them for twelve months. EE bonds will never decline in value. At a minimum, the U.S. Treasury guarantees that after twenty years, an EE bond will at least double in value. If an EE bond does not double in value as the result of applying the fixed rate for twenty years, the U.S. Treasury will make a one-time adjustment at original maturity to make up the difference. EE bonds earn interest for thirty years. EE bonds purchased before June 2003 are guaranteed to double in less than twenty years. What's more, an EE bond initial investment is as low as $25, rather than $1,000 for a Treasury security. As discussed later, these bonds can provide several tax advantages, particularly with regard to higher-education expenses.
EE bonds have a small reduction in liquidity in that you cannot redeem them for the first twelve months that you hold them. If you redeem them in the first five years from your purchase date, you will lose the last three months of interest.
EE bonds are subject to estate, inheritance, and gift taxes whether federal or state. Before September 1, 2004, exchanging old E bonds or EE bonds for HH bonds enabled you to defer reporting the taxable income of these bonds. Since September 1, 2004, you can no longer do this. We'll discuss HH bonds later in this chapter.
The difference between the purchase price and the amount you receive when you cash in your EE bonds or I bonds is reported as taxable interest income, which is subject to federal income tax but not state or local income tax. The interest income earned on EE bonds may be reported on your federal income tax return in one of two ways:
The first and usual way is to report all the income earned in the year in which you redeemed the bonds. If the taxpayer is your child, is over eighteen, and elects to cash in the bonds, he or she may pay a lower tax on the postponed interest income if in a lower tax bracket than you. But keep in mind the possible exclusion of taxes on all EE bond interest if you (but not your child) are the owner of the EE bonds and you use the cash from the redeemed bonds for college tuition (see "Special Features" later in this chapter).
The second way is to report the increase in redemption value as interest income each year even though you do not receive any cash. This approach may have advantages. For example, when a low-income taxpayer who has no other taxable income owns an EE bond, it might be advantageous to report the interest income yearly. This may enable the low-income taxpayer to reduce paying tax when he or she later redeems the bond.
If you want to change your method of reporting savings bond interest from the first way to the second way, you can do so without notifying or getting permission from the IRS. However, when filing your federal income tax return for the year you change, you must include on that return all savings bond interest accumulated to date that you have not previously reported.
If you want to do the opposite, change your method of reporting savings bond interest from the second way to the first way, you can do so by requesting permission from the IRS. The IRS automatically grants permission for the change if you send it a statement that meets a number of requirements set forth in IRS Publication 550, Investment Income and Expenses. You can find this publication atwww.irs.gov.
If you are a surviving co-owner and the decedent (for example, your deceased husband or wife) had postponed reporting the interest income while he or she was alive, there are two choices for reporting the deferred interest income:
You can report all the postponed interest income on the decedent's final federal income tax return. In this case, you will not have to include any of this income in your federal income tax return. You would include only interest earned after the date of death.
You can report all the interest income earned before and after the decedent's death on your federal income tax return.
The Education Savings Bond Program, which applies to both EE bonds and I bonds, offers significant tax advantages to qualifying individuals. The Treasury Department introduced this program in 1990 as a response to the soaring costs of higher education.
If you qualify, this program allows you to exclude from your income all or part of the taxable interest income you receive on the redemption of your EE or I bonds. This exclusion applies to qualified higher-education expenses that you pay for yourself, your spouse, or any dependent for whom you are allowed a dependency exemption on your federal income tax return. The exclusion only applies for tuition paid to an eligible institution or state tuition plan.
To exclude some or all of the taxable interest income from your savings bonds, you must meet all the following requirements: Year of purchase. You must have purchased EE bonds in January 1990 or later. All I bonds are eligible for this program. You are not required to indicate that you intend to use the bonds for educational purposes when you buy them.
Age. You must be at least twenty-four years old on the first day of the month in which you bought the savings bonds.
Registration. When using the bonds for your child's education, the bonds must be registered in your name and/or your spouse's name using one of your Social Security numbers. You can list your child as a beneficiary on the bond but not as a co-owner. If you list your child as a co-owner, the bond does not qualify for the income exclusion. When using bonds for your own education, you must register the bonds in your name. If you are married, you must file a joint return to qualify for the exclusion.
Year of redemption. You must redeem the bonds in the year you pay the tuition. You must use both the principal and interest from the bonds to pay qualified expenses in order to exclude the interest from your gross income.
Qualified institutions. You must pay the tuition to post-secondary institutions, including colleges, universities, and vocational schools that are eligible to participate in a student aid program administered by the U.S. Department of Education.
Qualified expenses. Qualified educational expenses include tuition and fees (such as lab fees and other required course expenses) at an eligible educational institution. The expenses may be for the benefit of you, your spouse, or a dependent for whom you are eligible to claim an exemption on your federal income tax return. Expenses paid for any course or other education involving sports, games, or hobbies qualify only if required as part of a degree or certificate-granting program. The costs of books and room and board are not qualified expenses.
Income limits. The full interest exclusion is available only if your income is under a certain limit in the year you use EE or I bonds for educational purposes, not the year in which you buy the bonds. In tax year 2006, for example, the IRS eliminated the exclusion for single taxpayers with modified adjusted gross incomes of $78,100 and above and for married taxpayers filing jointly with modified adjusted gross incomes of $124,700 and above. Married couples must file jointly to be eligible for the exclusion.
If you meet all these requirements, and certain additional qualifications, and you cash in your EE or I bonds and use them for college tuition, some or all of the interest earned on the bonds will be tax free. IRS Form 8815, the instructions for this form, and IRS Publication 970 explain all the technical requirements. You can find these documents at www.irs.gov. Thus, if you satisfy all the requirements, EE or I savings bonds may be as tax-efficient as investing in tax-free municipal bonds. Moreover, in certain cases you might receive a higher return on savings bonds than on municipal bonds.
EE bonds provide a tax deferral for up to thirty years, whereas other bonds (except for tax-free municipal bonds) are subject to annual federal income taxes.
EE bonds have no market risk and will never decline in value— a very helpful feature in your financial planning. At a time of low interest rates, you might purchase EE bonds and hold them until the interest rates on other bonds go up and then cash in your EE bonds and buy the higher-yielding bonds. Keep in mind there is a restriction on this strategy: You must hold your EE bonds for at least twelve months, and if you sell them before five years, you will have to pay a penalty of three months' interest.
EE bonds increase in value on the first day of each month. Thus, if it is near the end of the month when you plan to redeem your bonds, you may want to wait until the first day of the next month to earn a full month's interest. For example, if you planned to cash your bonds on March 28, you would lose interest for the entire month of March. If you can wait until April 1 to redeem your bonds, you would earn interest for the entire month of March.
When held for a long time, EE bonds may result in a large tax liability in the year you redeem them. One tax-planning technique is to gift your EE bonds to an individual over eighteen who is in a tax bracket lower than yours before you cash in the bonds. The person who cashes in the EE bonds must report the interest income on their federal income tax return.
As of September 1, 2004, the U.S. Treasury is no longer issuing HH savings bonds. Thus, investors are no longer able to reinvest their EE bonds in new HH bonds as they could before September 1, 2004. The description of HH bonds that follows applies only to HH bonds issued before September 1, 2004.
HH bonds pay out interest every six months at a fixed rate set on the day you bought the bond. HH bonds do not increase in value. Instead, every six months you receive a payment in cash by a direct deposit to your checking or savings account equal to six months of interest on your HH bond. When you purchase an HH bond, you lock in this rate for the first ten years. Interest rates are reset on the tenth anniversary of the HH bond's issue date. Bonds issued on January 1, 2003, through August 2004 earn 1.5 percent interest for their initial ten-year maturity period. Bonds entering an extended maturity period beginning January 2003 or later earn interest at 1.5 percent each year. Bonds issued March 1993 through December 2002 earn interest at 4 percent each year until they enter extended maturity after the first ten years. After that, they start earning interest at 1.5 percent each year. HH bonds reach final maturity and stop earning interest twenty years from their issue date.
HH bonds are free of default risk because the U.S. government guarantees them. They have no liquidity risk because you can redeem them at face value at any time. If you exchanged EE bonds for HH bonds before September 1, 2004, you can continue to defer paying federal income taxes on the interest accrued on your EE bonds until the end of the extended due date. This may be of value if you exchanged your EE bonds for HH bonds before January 1, 2003, and are earning 4 percent while continuing your deferral. However, with the interest rate set at 1.5 percent for exchanges made after December 31, 2002, you may want to cash in your HH bonds (see "Tax Implications").
Cashing in HH bonds may result in a large tax liability in the year you redeem them. The reason is that if you held the EE bonds for a long time before exchanging them for HH bonds, there may be a bunching of income in one year at a high federal income tax rate.
You must report the payments you receive from HH bonds as interest income on your federal income tax return for the year you earn it. This income is not subject to state or local income taxes.
You must report any deferred interest from savings bonds that you exchanged to buy HH bonds as taxable income on your federal income tax return at the earlier of the year in which (1) your HH bonds reach final maturity or (2) you cash your HH bonds prior to final maturity.
Let's look at an example of the tax treatment of deferred interest. Assume that you bought an EE bond twelve years ago for $500 and it was worth $1,000 on August 1, 2004 (before the September 1, 2004, deadline). If on August 1, 2004, you traded your EE bond for an HH bond worth $1,000, you would continue to postpone reporting the $500 of interest income you earned on your EE bond until you cash in your HH bond or until the HH bond reached final maturity. However, the interest income you earn on your $1,000 HH bond every six months will be subject to federal income tax each year.
The I bond was first issued in September 1998. It is more complex than the EE bond. Interest is accrued and added to the I bond monthly and compounded semiannually. However, you do not pay tax on the accrued interest until you redeem the bond.
The I bond's earnings rate is composed of two separate rates: a fixed rate of return and a variable semiannual inflation rate. When these two rates are combined, they produce the composite earnings rate on the I bond. The Treasury Department sets the fixed rate of return twice a year, each May 1 and November 1. The announced fixed rate applies only to bonds purchased during the six months following its announcement. The fixed rate that's in effect for the six-month period during which you buy your I bond remains your fixed rate for the thirty-year life of your bond. Between September 1, 1998 (when I bonds were first introduced), and May 1, 2006, for example, the fixed rate ranged from a low of 1 percent in November 2005 to a high of 3.6 percent per year in May 2000.
The semiannual inflation rate changes every six months, and the Treasury Department announces it each May 1 and November 1. The inflation rate is computed using the consumer price index for all urban consumers, published by the Bureau of Labor Statistics. The semiannual inflation rate announced in May is a measure of inflation over the preceding October through March; the inflation rate announced in November is a measure of inflation over the preceding April through September. From September 1, 1998, to May 1, 2006, the inflation rate ranged from a low of 0.28 percent in May 2002 to a high of 2.85 percent in November 2005.
As we've noted, the composite earnings rate on your I bond is computed by combining the fixed rate and the inflation rate according to a set formula. An I bond's composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in August 2002 changes every August and February. However, the formula used to calculate the composite rate is more complicated than simply adding together the fixed rate and the semiannual inflation rate (see Figure 7.1).
The composite rate of 4.4 percent applies for the first six months after the issue. This composite rate combines the 2 percent fixed rate of return with the 1.19 percent semiannual inflation rate as measured by the consumer price index. In effect, if you purchased I bonds issued between May 1, 2001, and October 30, 2001, you would earn a 2 percent fixed rate of return over and above inflation for the thirty-year life of the bond.
Figure 7.1. The Formula for the Composite Earnings Rate for I Bonds Issued from November 1, 2001, to April 30, 2002
The example provided in Figure 7.1 assumes that each year there will be at least some inflation. However, it is possible that there may be deflation in one or more years you hold your I bond. In the case of deflation, your I bond's composite rate will be lower than its fixed rate. That's because instead of an inflation rate being added to your fixed rate, the deflation rate will be subtracted from your fixed rate. Deflation will cause an I bond to increase in value slowly or not at all during the period of deflation.
A safety guarantee is built into the I bond to protect you in case the deflation rate exceeds your fixed rate. The terms of the I bond provide that no matter how bad deflation gets, the composite rate will never be reduced below zero. In the case in which the deflation rate exceeds the fixed rate, the redemption value of your I bonds will remain the same until the composite rate becomes greater than zero. For example, if your fixed rate is 2 percent and the deflation rate is 1 percent for the year, your composite rate for the year will be 1 percent (2 percent minus 1 percent). If your fixed rate for the year is 2 percent and the deflation rate is 3 percent, your composite rate for the year would be 0, because the composite rate cannot be reduced below zero.
The Treasury Department provides all the rates and detailed calculators on its Web site, www.TreasuryDirect.gov. Go to the Savings Bond Calculator to find the value of your bonds and what they are earning currently.
I bonds are guaranteed to protect the holder against the risks of inflation and are also guaranteed to keep their value even if there is deflation. I bonds have no market risk because you can redeem them at their computed value from the Treasury Department at any time after twelve months. In addition, I bonds generally have all the same advantages we've noted for EE bonds.
Unlike EE bonds, which guarantee a minimum rate of return, I bonds do not guarantee a minimum level of earnings. In addition, although I bonds generally increase in value monthly, they can stop accumulating interest in periods of deflation.
I bonds have a small reduction in liquidity in that you cannot redeem I bonds for the first twelve months you hold them, and if you redeem them in the first five years from your purchase date, you will lose the last three months of interest.
I bonds stop earning interest thirty years from the issue date. When your I bonds reach final maturity in thirty years, you must redeem them and report all the interest in the year of redemption.
The taxation of I bonds is generally the same as noted for EE bonds. The Education Savings Bond Program applies to I bonds just as it does to EE bonds.
I bonds and EE bonds are an effective tax-deferral vehicle if you have contributed fully to all your tax-sheltered retirement accounts—such as your 401(k), 403(b), IRA—and you still want an investment that will provide a tax deferral.
The amount of EE bonds you buy does not limit the amount of I bonds you can purchase. If you're single, you can buy $30,000 per year in I bonds. If you're married and want to buy more, you and your spouse can each buy another $60,000 per year of I bonds. You could accomplish this by registering $30,000 of these bonds in separate names as individual owners. In addition, another way to register the bonds as a couple is to put your name as the first co-owner together with your Social Security number and list your spouse's name (without Social Security number) as the second co-owner on the first bond. On the other bond, do the opposite: put your spouse's name and Social Security number as the first co-owner and list your name (without Social Security number) as the other co-owner.
Keep in mind that the EE bond rate will be fixed for at least twenty years; nevertheless, you can redeem your bond after twelve months with only a three-month interest penalty if the redemption takes place within five years of your purchase. In comparison, only part of the I bond rate is fixed for the thirty-year life of the bond, but the added inflation rate will change every six months. If you're just starting out your investing career and don't have much money to invest, these bonds are a good starting place.
What is the current fixed rate on I bonds, including the current inflation rate?
Will the interest-rate deferral that EE and I bonds provide be offset by a bunching of income in the year you redeem your bonds, making these bonds less attractive?
If you, your spouse, or a dependent will be paying college tuition in the future, will you be in a low enough tax bracket to use the exclusion from income for education expenses?