For births, birthdays, holidays and graduations, parents and grandparents used to have a go-to gift: U.S. savings bonds. They could be bought for a few dollars, paid interest for decades, were backed by the full faith of the government, taught children about the magic of compounding and could someday help with college costs tax free.
But you don’t hear much about savings bonds these days. Some may find their way to children’s hands over the next few weeks, but many families have caught on to the fact that for every benefit conferred by a savings bond, some other product now does it better.
“In my opinion, there are much better options available for nearly every [purpose] a savings bond could be used for,” says Cameron M. Brady, vice president of Michael Brady & Co., a wealth management firm in Westlake, Ohio.
[See: 7 of the Best Stocks to Buy for 2018.]
The bonds come in two types: the 30-year EE bond that pays a fixed interest rate for 20 years, with the rate possibly changing for the following 10 years; and the 30-year I bond, which pays a small fixed rate on top of a variable rate meant to keep up with inflation.
Both can be purchased directly from the government through the Treasury Direct website for as little as $25. New EE bonds are offered only in electronic form, and I bonds in electronic form or paper if bought with a federal tax refund.
But there are some downsides:
Yields. “Interest rates are very low,” says Peter J. Creedon, CEO of Crystal Brook Advisors in New York. “The current rate for new EE bonds is 0.1 percent so you are currently earning a below inflation rate of return.”
As Creedon says, EE bonds sold between Nov. 1 and next April 30 will pay just 0.1 percent for the first 20 years. I bonds purchased in this period currently earn a 0.1 percent fixed rate, plus 2.48 percent inflation rate, which is adjusted every six months, for a grand total of 2.58 percent.
The I bond yield isn’t bad compared to comparably safe savings like bank accounts, and the I bond will pay more no matter how high inflation goes. But you don’t have to tie your money up for the best yields today, thanks to products like exchange-traded funds owning preferred stocks, or real estate investment trusts, many paying in the high single digits.
Annual limits. An individual can invest no more than $10,000 a year in savings bonds, but $18,000 in a 401(k) and $24,000 if older than 50. There’s no limit on investments in ordinary taxable accounts.
Ease of purchase. In the good old days, people bought savings bonds at the bank or with a payroll deduction. Now the bonds can be purchased through TreasuryDirect.gov with a few minutes online. But many other financial products are available through online services — everything from bank savings to stocks, mutual funds and ETFs. Even bitcoin.
No steady income. Savings bonds don’t pay interest regularly. Instead, earnings are added to the bond’s value and collected when the bond is redeemed. Many of the alternatives mentioned above pay monthly or every six months, making them better for investors who need income.
[See: 7 Utility Stocks with Powerful Dividends.]
Lack of liquidity. Savings bonds cannot be redeemed for the first 12 months, and carry a penalty of loss of three months interest if redeemed in the first five years. Money market funds and interest paying bond funds can be unloaded at any time without penalty, even if there sometimes are restrictions on trading in and out too quickly.
Alternatives for education. “When you redeem the saving bonds, the difference between what you paid for them and what you redeem them for is taxable as ordinary income unless used for a specific exempted reason, such as higher education,” Creedon says.
Earnings on savings bonds are exempt from federal tax if used for qualified higher education expenses. But nowadays investors get the same tax-free treatment for gains in Section 529 plans and Coverdell Education Savings Accounts, and these alternatives offer more generous investing options like stocks or pre-paid tuition. (Coverdell contributions are limited to $2,000 a year, however.)
Also, owning or redeeming savings bonds can hurt a student’s prospects for financial aid, Creedon says.
If not used for education, interest on savings bonds is deferred until the year the bond is redeemed (it is exempt from state and local tax), then taxed as ordinary income. But individual retirement accounts and 401(k)s offer the same tax deferral, while gains in Roth versions of those plans are tax free.
Inflation protection. Today’s EE bonds earn less than the recent inflation rate, meaning they are losing value.
The two-part yield on I bonds is meant to assure the earnings always beat the inflation rate, with the inflation adjustment made every six months based on the consumer price index.
But the government now also offers Treasury Inflation-Protected Securities, or TIPS, that do the same thing slightly differently. TIPs are more liquid and you can invest as much as you want and get out without penalty, or leave the hard work to the pros by buying them through a mutual fund.
Also, many people drawn into investing by the ballooning mutual fund industry have discovered that stocks, while riskier than savings bonds over the short term, have generally provided plenty of inflation protection.
Savings bonds are safe but not particularly generous, and, as Brady says, there are many alternatives today.
[See: 7 Ways to Invest for Income.]
“For education, people now have options with 529s and Coverdell ESAs,” he says. “Looking for a cash alternative? Look at CDs, or even low-duration ETFs and mutual funds. Want to give your grandson a gift? Set up a [uniform transfers or gifts to minors account] and teach them the fundamentals of investing as opposed to giving them the gift of future cash with minimal growth.”
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7 Ways Savings Bonds Fall Flat originally appeared on usnews.com
