How Do Savings Bonds Work? (Tips for 2020)

According to a new study, only 8% of American adults can define fixed-income investments and how they work correctly.

Out of the remaining 92%, 56% didn’t answer correctly, whereas 36% couldn’t define anything about fixed-income investing.

Fixed-income investments are a critical part of a well-diversified portfolio. Unfortunately, over 50% of Americans have failed to diversify their investment portfolio despite the last stock market crash.

In our opinion, the best way to defeat ignorance is to equip people with the right kind of knowledge.

This post will focus on how do savings bonds work, their different types, how one can purchase them, and questions surrounding their redemption.

Before we move forward with this article, here is a list of some of the best CD rates available for conservative investors.

Let’s find out more about savings bonds.

What are savings bonds?

Savings bonds are a tool to raise capital from investors, buyers by offering them interest against their money. Savings bonds are investment instruments that provide a guaranteed rate of return to their procurers.

The first savings bonds were issued in the US in 1935, launched in four successive Series (A, B, C, D), also known as “baby bonds.” The denominations for these bonds were between $25 to $1,000. These bonds helped the US Treasury Department raise roughly $4 billion between 1935 and 1941.

Savings bonds played a critical role in the US, with the US Treasury using Series E savings bonds to fund the second world war. These were also called “Defense Bond” or “War Bond.” The last of these bonds matured in 2010.

There have been several issues since then, including Series EE, H, HH, and I. As an investor, you can purchase Series EE savings bonds that have been in circulation since 1980 or any other bonds.

How do savings bonds work?

Now that you know how the first savings bonds were released let’s find out some basic terms that every bond investor must know.

  • Issue date: The issue date of a bond is the one after which a bond starts accruing interest.
  • Maturity: Maturity date is the time when a bond matures. The issuer has to repay the principal amount to the bondholders at the time of maturity.
  • Secured or unsecured: A secured bond is backed by some collateral, which plays a critical role in repaying the principal amount in case of bankruptcy. An unsecured bond doesn’t hold any collateral and might result in the loss of the principal amount altogether.
  • Coupon rate: It is the interest rate at which a bond accrues interest. The coupon rate is often called a nominal yield.
  • Tax status: The tax status of the bond decides whether the interest is taxable or not. Most corporate bonds are taxable, but you can find tax-free government or municipal bonds.
  • Callability: Callable bonds have a provision that allows an issuer to pay off the principal amount before maturity, usually with a premium.

The core principle behind savings bonds is similar to a loan you might give to someone and charge interest for it.

In the case of US savings bonds, you are lending your money to the government. The government will make regular interest payments (monthly, quarterly, or annually) to the bondholder.

For instance, if you have a $1,000 bond with a coupon rate of 5%, you’ll receive $50 in annual interest. The interest can be paid monthly, quarterly, or annually.

Do understand that the bonds can have fixed or variable interest rates. In case of variable interest rates or coupon rate, the rate is linked to a benchmark, such as Libor (London Interbank Offered Rate).

Understanding the different types of savings bonds

The US Treasury has issued multiple types and Series of bonds over the years. As of now, you can purchase Series EE and Series I bonds.

Series EE Bonds

Series EE Bonds

The Series EE Bond is a US Government savings bond, also known as a “Patriot Bond.” Unlike corporate bonds, Series EE bonds are non-marketable, which means you cannot buy them in the open market.

The Series EE bonds are some of the lowest risk investments available currently. The interest you earn on these bonds is exempt from local or state taxes, though you’ll have to pay federal taxes.

Prior to January 1, 2012, one could buy paper bonds from financial institutions or directly through the mail, but the US Treasury only issues electronic bonds now.

The available denomination for Series EE bonds is $25 and above, although you can find paper bonds in $50, $100, $200, $500, and $1,000 denominations. You can purchase a maximum of $10,000 worth of Series EE bonds in a calendar year.

Paper bonds were more attractive as you could buy them for half of their face value. A paper bond worth $100 was sold for $50. Electronic bonds, on the contrary, are available at their face value.

Interest rate

The Series EE bonds issued after May 2005 have a fixed rate of interest. The standard procedure is to add monthly interest payouts to the bond itself and pay it at the time of cashout.

A US Treasury savings bond continues earning interest for up to 30 years, offering steady returns to the bondholder.

The ongoing rate for Series EE bonds is 0.10% for all the bonds issued between May 2020 and October 2020.

Redemption terms

You have to keep a Series EE savings bond for at least one year before cashing out. If you cash out a Series EE savings bond before 5 years, you’ll lose the interest for at least three months.

Any redemptions done after 5 years are penalty-free.

Tax treatment

You don’t have to pay local or state taxes on savings bonds, except inheritance or estate taxes. Any interest income you earn is subject to federal income taxes unless you use it for qualified educational expenses.

Series I Bonds

Series I Bonds

The Series I Bonds are US Government savings bonds that contain a fixed and a variable interest component (linked to inflation). Unlike Series EE bonds, Series I bonds come with protection against inflation, thereby maintaining the purchasing power of your funds.

The US Treasury adjusts the inflation-linked interest rate every six months (May and November), whereas the fixed interest rate remains the same for the life of the bond.

You can buy Series I bonds in denominations of $25 or more for electronic bonds, and $50, $100, $200, $500, and $1,000 for paper bonds.

In any single calendar year, you can purchase electronic Series I bonds worth $10,000 and paper bonds worth $5,000.

Interest rate

The current rate for Series I bonds stands at 1.06% for bonds issued between May 2020 and October 2020. The total interest rate is calculated by combining the fixed interest rate and the semiannual inflation rate.

The fixed interest rate on Series I bonds is compounded semiannually. If the inflation rate is negative, the US Treasury considers a 0% inflation interest rate for that period.

The interest is paid when you cash Series I bonds.

Also, Series I bonds are sold on face value, i.e., a $50 bond costs $50 only.

Redemption terms

You’ll have to hold onto your Series I bonds for at least one year before cashing it out. The bond continues earning interest for up to 30 years.

You’ll lose the interest of up to three months if you cash the bond within 5 years of its issuance. There are no penalties after 5 years.

Tax treatment

The interest you earn on Series I bonds is exempt from local or state taxes. You’ll have to pay federal income taxes, but there is an exemption for qualified education expenses.

How can you purchase savings bonds?

A couple of years ago, you could just walk into a bank and buy a paper bond, but the trend has changed since 2012.

You can purchase Series EE and Series I bonds online through the website. Alternatively, you can also buy Series I paper bonds using your income tax refund.

Add IRS Form 8888 with your income tax return. You’ll have to mention what portion of your refund should be used to purchase bonds and how much should be returned. Series I bonds are available in multiples of $50 only, so adjust your figures accordingly.

You can purchase up to $5,000 worth of Series I paper bonds against your social security number in any calendar year.

If you want to purchase savings bonds using a portion of your salary, the Treasury Department allows you to buy savings bonds through payroll deductions. Here is what you need to do:

  • Check whether your employer offers voluntary payroll deductions.
  • Set up a TreasuryDirect account to purchase savings bonds.
  • Share your TreasuryDirect account number as well as the routing number with your payroll department. Make sure to mention the amount of your deduction.
  • Schedule bond purchases in accordance with the payroll deduction period.

How to redeem savings bonds

Now that you know how do savings bonds work, their different types, interest terms, and how to buy them, it’s the right time to learn about cashing out these bonds.

Before we move forward with the process, let’s just quickly remind ourselves that you can redeem a bond only after a year of its issuance. Plus, if you redeem it within 5 years, you’ll lose the interest of up to three months.

  • Redeem electronic bonds through TreasuryDirect: One of the easiest ways to redeem your electronic bonds is through TreasuryDirect. Log in to your TreasuryDirect account and follow the instructions for redemption. You can request a direct deposit to your associated account.
  • Contact your local bank to redeem paper bonds: If you happen to own paper bonds, you can visit a local bank to redeem your savings bonds. It is best to contact the bank before you visit for redemption. Also, some banks may have specific restrictions or limitations when it comes to redeeming savings bonds, especially for non-customers, so call upfront.
  • Mail your paper bonds to the Treasury Department: Last but not least, you can mail your paper bonds to the Treasury Department directly. You will have to send some details, such as your social security number and information for processing the deposit, on FS Form 5396.

What are the pros and cons of investing in savings bonds?

Pros of investing in savings bonds

  • Low-risk investments: The most important benefit of investing in savings bonds is their risk-free nature. There are very slim chances of the US Government not coming through on its debt, so your investments are safe. If you’re someone eyeing capital preservation, low-risk investments should be a part of your portfolio.
  • Tax exemptions: The IRS does offer tax exemptions on interest if you’re using it to finance qualified educational expenses. Do understand that these exemptions are applicable on the federal level, so make sure to check your income guidelines before investing in bonds.
  • Portfolio diversification: Savings bonds offer portfolio diversification. They provide a hedge against market volatility. Additionally, you’ll continue receiving investments for the entire maturity period, i.e., 30 years.

Cons of investing savings bonds

  • Lower returns: With safety comes lower yields, and savings bonds are the best example of this investment cliche. Savings bonds fall short on returns, especially when compared with market-linked products. It is critical to examine the returns you might book with other investments, especially when investing for three decades.
  • No liquidity: Savings bonds lack liquidity. You have to wait a minimum of one year to cash a bond. Additionally, cashing your savings bonds before five years may even lead to an interest penalty.
  • Lack of consistent income: For investors seeking regular income, savings bonds may or may not provide monthly income. Although, some DIY financial advisors or experts suggest applying a laddering strategy to achieve steady income through savings bonds. Nonetheless, it’s a long shot and will require a lot of planning.
  • Interest penalty: When you redeem savings bonds before 5 years, you lose the interest of up to three months. Not only is your money stuck, but you may end up losing a portion of your interest in case of an emergency withdrawal.

Are savings bonds right for you?

Savings bonds have long served as a sound investment vehicle. It wasn’t common until a couple of decades ago for grandparents to gift savings bonds to grandchildren.

To answer whether savings bonds are right for your portfolio, we have to start by analyzing your financial goals.

Why do you want to invest in savings bonds?

There are multiple reasons to start with, such as capital preservation, diversification, and tax benefits.

If you’re trying to diversify your portfolio by adding some low-risk investments, savings bonds will do the trick. However, it is critical to take into account the rate of return bonds offer.

Financial advisors suggest every investor should add savings bonds to his portfolio, but the portion may vary depending on your age. For instance, if you’re 30 years old, you can dedicate up to 20% of your portfolio to fixed-income products, such as savings bonds.

On the contrary, if you’re 80 years old, you may want to invest anywhere between 70% and 80% of your portfolio in savings bonds to minimize risk.

For individuals seeking capital preservation, bonds offer a good solution, although you should consider the impact of inflation on your funds. If you want to preserve your principal, we suggest investing in Series I bonds as they offer protection against inflation.

The tax benefits bonds offer is another reason you may want to invest in savings bonds. You won’t have to pay state or local taxes on interest income, though federal taxes would still apply. Individuals in high-income brackets can benefit from these tax breaks.

Here is what you can do:

  • List your financial goals.
  • Find out what portion of your portfolio should be dedicated to fixed-income products. You can seek professional help.
  • Use these funds to purchase savings bonds.

Summary (Our Recommendations)

Savings bonds are ideal for investors seeking low-risk, fixed-income investments. They may not offer the best returns, but you can rest assured that your principal is safe.

Here is what we recommend when it comes to savings bonds:

  • Analyze your investment goals: Savings bonds offer multiple benefits, so you have to identify how they fit your portfolio.
  • Diversify your portfolio: No matter the size of your investment portfolio, you’ll need some low-risk investments to diversify your portfolio. Savings bonds are an ideal instrument for diversification.

That marks the end of this post, but before we conclude, here is a list of some of the best CD rates available in the market. CDs offer a secure way to preserve and invest your capital. Your CDs are insured up to $250,000.

Do you invest in savings bonds? Kindly share your investment goals and how savings bonds fit into your portfolio.

Leave a Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.