Raise your hand if there’s a U.S. savings bond in your safe deposit box.
No? Well, that’s not too surprising. Once upon a time, savings bonds were one of Americans’ top investment choices. But now your portfolio is more likely to be crammed with mutual funds, exchange-traded funds, individual stocks and bonds. Instead of regularly buying savings bonds at work, you probably steer money into a 401(k).
But savings bonds still exist — in two flavors, in fact — and can still serve well for some purposes such as saving for college. And the newer variety, inflation-indexed bonds (I-Bonds), can protect your money from the ravages of inflation.
[See: 15 Money Management Tips for College Students.]
“U.S. savings bonds certainly have been declining in usage, but are still issued and purchased by individuals as in the past for gifts,” says Craig Bolanos, CEO of Wealth Management Group in Inverness, Illinois. “Individuals receiving U.S. savings bonds tend to be children and adolescents for birthdays, graduations, and celebrations.”
“I-bonds are suitable for those who desire safety above anything else,” says Matt Hylland of Hylland Capital Management in Virginia. “The interest payments on I-bonds are indexed to inflation, and their payments will increase as inflation increases. They are also guaranteed by the U.S. government, making them the safest investment available. I-bonds are guaranteed to keep up the purchasing power of your savings, but will certainly not make anyone rich.”
Interest payments from I-bonds come in two parts. First is a fixed rate that stays the same for the life of the bond. At the current level of 0.10 percent, they can’t be called generous. But on top of that is the variable, or inflation-indexed rate, adjusted every six months to match inflation. Together, the two rates currently yield 0.26 percent.
Because the variable rate will always keep up with inflation, you can be sure that money put into an I-bond will not lose buying power. In fact, the fixed rate on top of the inflation adjustment will guarantee that your investment will grow in value. Even if the U.S. were to enter a period of deflation, the government guarantees that the combined rate will never be lower than zero, though the combined yield could be lower than the fixed rate during a deflationary period.
The second type of savings bond is the more traditional EE bond, currently paying 0.10 percent. But the government also promises that the EE bond will double in value over 20 years, so that a bond bought for $25 can eventually be redeemed for $50, a 3.52 percent annual return, according to Hylland.
EE bonds can only be purchased in electronic form, not on paper, and are limited to $10,000 worth per person per year. An individual is limited to $10,000 in electronic I-bond purchases per year, plus $5,000 in paper I-bonds.
Because of the inflation protection, I-bonds are similar to Treasury inflation-protected securities, which rise in value with inflation. So for many investors the choice comes down to I-bonds versus TIPS.
[See: 11 Tips for the Sandwich Generation: Paying for College and Retirement.]
There is no limit on TIPS purchases, making them more desirable for people who want to invest large sums.
On the other hand, while you cannot lose money on a savings bond, you can lose with a TIPS if you pay a premium, or if prices have fallen and you must redeem before the bond matures.
“Because TIPS are auctioned off like other Treasurys and trade on a secondary market, they may trade above their par value, like they are today,” Hylland says. “If an investor purchases a TIPS above its par value, and inflation remains very low, and if we experience negative real interest rates, the return on TIPS can become negative, where I-bonds are limited to a (minimum) rate of zero percent.”
Like most bonds, TIPS can lose value when rising interest rates make older, stingier bonds less attractive. That doesn’t happen with savings bonds because they are not traded on a secondary market. On the flip side, though, TIPS can go up in value if interest rates fall, while savings bonds cannot.
Savings bonds can be redeemed at any time 12 months or more after purchase, but if you cash one in during the first five years you lose the last three months’ interest. TIPS can be sold at any time without penalty.
Interest earnings on both types of bonds are taxed as income on the federal return, but are exempt from state and local taxes. But there is one key difference: Tax on TIPS is due the year the interest and inflation adjustment are applied, while tax on savings bonds earnings is not due until the bonds are redeemed.
Also, federal tax is waived for savings bonds used to pay for higher education. To qualify, the bond must be purchased in the name of someone at least 24 years old at the time — typically a parent or grandparent — and the student must be listed on the bond as the beneficiary but not as a co-owner. The exclusion is phased out for individuals earning more than $77,200 and for couples earning more than $115,750.
So what is the best use for savings bonds?
[Read: 5 Questions to Ask a Fiduciary.]
“I-bonds may be suitable for those saving for higher education costs,” Hylland says. “The interest on I-bonds does not count toward your gross income if the bonds are used for qualified education expenses. The returns on I-bonds are so low they may not be suitable for everyone. But for those savers looking to simply keep money safe, I-bonds offer a tax friendly way to save for education expenses.”
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How I-Bonds Can Help Pay for College originally appeared on usnews.com
