i bonds

7 Reasons Why I Savings Bonds Are a Good Choice for New Investors

Michael Kling — Fri, 20 Sep 2013 10:18:20 +0000

For new investors worried about risk and challenged by high minimum requirements, U.S. Savings Bonds, particularly I Bonds, offer a great alternative. When you buy a Savings Bond, you essentially lend money to the U.S. government, which pays you interest in return. (See also: 5 Super Safe Investments)

An I Bond interest rate is a composite of a fixed rate that stays the same and a variable rate that changes every six months based on the Consumer Price Index. The combined rate will never be less than zero, even if there is deflation and prices are falling. Interest is earned monthly and compounded twice a year.

The government also offers EE Saving Bonds, which are similar to I Bonds, but pay fixed interest rates. EE Bonds offer the same safety, tax advantages, and low minimums as I Bonds. However, because EE Bonds sold since 2005 feature fixed rates, they don't offer the same protection against inflation.

Here are seven reasons why I Bonds are a good investment.

1. Safety

They are safe. Stock prices rise and fall, sometimes substantially. Their proponents say stocks offer the best long-term return, but stocks can drop or remain flat over long periods, like the 1970s or early 2000s. Bonds are generally seen as safer, yet bond values fall when interest rates rise, meaning you can lose money.

I Bonds are arguably even safer than bank CDs and savings accounts insured by the government (FDIC). Instead of keeping your money in bank accounts insured by the government, you lend it to the government itself.

2. Low Minimums

A Savings Bond can be purchased for as little as $25. By comparison, bank CDs typically require at least $500 or $1,000. Mutual funds require at least $2,500. Some want $5,000 to start, a tough hurdle for beginning investors.

3. Favorable Tax Treatment

I Bond interest is not subject to state or local income tax. You don't pay federal income tax until you redeem them and pocket your interest. (See also: Tax Penalties for Early Retirement Withdrawals)

4. Deductible Educational Expenses

You may be able to avoid paying taxes on your interest if you have "qualified education expenses." Qualified expenses include tuition and fees and expenses paid for a course required for a degree or certificate, but not books or room and board.

Educational expenses for your child can qualify if the bond is registered in your name or spouse's name. Expenses for your spouse may qualify if you file a joint return.

5. Inflation Protection

I Bonds can be used to protect yourself against inflation because their interest rate is adjusted twice a year based on the Consumer Price Index. So if inflation increases, the bond's interest payment also increases, an important consideration when many investments lose value due to inflation. (See also: Savings Rates Below Inflation? Save Anyway)

6. Retirement Income

Because they keep paying interest for 30 years and offer favorable tax treatment, I Bonds can be good source of supplemental retirement income. Favorable tax treatment is another retirement advantage. Since you only pay taxes on interest when redeeming the bonds, you could postpone taxes until you're retired and possibly in a lower tax bracket. (See also: Retirement Planning If You're Under 30)

7. Convenient to Buy

To purchase Saving Bonds, you have to set up an account at TreasuryDirect.com. Once the account is set up and linked with your bank account, buying them is as easy as a few mouse clicks. You don't have to worry about storing paper bonds. You can also set up an automatic payroll savings plan, if your employer participates in a plan.

You can use your tax refund to buy paper I Bonds in multiples of $50 up to $5,000. All you have to do is select the option by filing Form 8888. Except for I Bonds purchased with tax refunds, Savings Bonds are only sold electronically.

I Bonds have some drawbacks. You have to hold them at least 12 months before redeeming them. And if you redeem them within five years, you lose the last three months of interest.

Their rates are not spectacular. For instance, the composite rate, or combined fixed- and variable-rate, for I Bonds issued May 1, 2013 to Oct. 31, 2013, was set at 1.18 percent. Still, given their other advantages, I Bonds are a good choice for new — as well as experienced — investors.

Have you ever invested in I Bonds? Would you consider it?

Like this article? Pin it!

This article is from Michael Kling of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Savings Bonds as Interest-Earning Travelers Checks

Philip Brewer — Sun, 08 Nov 2009 14:00:01 +0000

Remember travelers checks? In the days before ubiquitous automated teller machines, they were a useful product. You could use them almost like cash — but you could carry more than you'd feel safe carrying in cash because if they were lost or stolen you could get them replaced. Well, savings bonds have all those features but one.

The thing you can't do with savings bonds is spend them like cash; you have to cash them in at a bank. (But then, I've sometimes had to cash travelers checks at a bank too.) In the US, pretty much any bank will cash US savings bonds. I assume there's something similar in other countries.

I first noticed this feature in the early 1980s — back before networked ATM machines made it easy to access the money in your accounts from anywhere you happened to be. Travelers checks were a useful tool for carrying your cash. But, when I noticed that several of their key features were shared with savings bonds, I started buying savings bonds instead — they paid interest. And I wasn't the only one. Anybody who needed to move around a lot — for example, military personnel — found them just as useful.

Basically, what you do is this: Buy savings bonds in small quantities over a period of time. This is easy to do; many employers let you buy savings bonds through payroll deduction and many banks will set up automated purchases as well. You can get them in all the denominations that you can get travelers checks and then some: $50, $75, $100, $200, $500, $1,000, and $5,000.

You can't cash the bond in until you've held it for a year, which is why I suggest buying gradually — you wouldn't want to put your whole emergency fund into savings bonds all at once. But, if you buy one every pay period or every month, pretty soon you'll have some that are more than a year old. Once that happens, they're basically just like travelers checks that you can only cash at the bank.

Go into pretty much any US bank with one or a few savings bonds (up to $1000 worth), and you can turn them into cash in just a few minutes. If they're lost or stolen or the paper certificate is damaged, you can get it replaced.

I've been enamored of savings bonds for a long time, but haven't talked about using them this way before here on Wise Bread, because they haven't had a competitive interest rate. Now, though, the rate on I bonds is looking pretty good.

As I mentioned back in July, the Consumer Price Index is about to surge. This isn't because inflation is rising (although I rather expect that to happen as well), it's just because it's now been a year since the big drop in oil prices.

The interest rate paid on I bonds is based on the CPI for the previous six months, so the effect of the oil price drop has already fallen off the calculation. Bonds purchased now will earn interest at a 3.36% annual rate for the next six months. That's a hard rate to beat in the current environment.

There's a 3-month interest penalty if you cash them in during the first 5 years, but even if you end up paying the penalty you still come out ahead compared to most vehicles for small savers. And if inflation rises (as I rather expect it to), the return just gets even better. Combine that with the features that make them like an interest-paying travelers check, and I think they're a pretty good buy right now.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

I Bond rates go to zero

Philip Brewer — Fri, 02 May 2008 14:47:57 +0000

Since 1998, the US Treasury has had a pretty good deal for small savers who were worried about inflation--the Series I Savings Bond. The interest it paid was based on inflation plus an additional return that was set by the Treasury and fixed for the life of the bond. On May 1st the Treasury announced the value of that fixed return for the next six months: Zero.

In two recent posts both I (in Savers suffering as rates fall--what to do) and Xin Liu (in A Simple Guide to Series I Savings Bonds (I-Bonds)) praised the return on the I Bond that was available through the end of last month. The fixed part of the return was just 1.2%, but added to the inflation rate, it was quite competitive with other rates that savers could get.

Even with a zero fixed rate, inflation is high enough that the composite rate comes in at 4.84%. (That's the annual rate you'll earn over the next six months if you buy a bond this month.) If you think inflation is going to stay high and other interest rates available to savers will stay low, then the I Bond is still a good deal--it's tough to beat 4.84% on other secure, short-term savings vehicles. Even so, I think the savings bond is a loser at this rate.

If inflation comes back down, the inflation portion of this bond will shrink, reducing your yield. You can't cash the bond in during the first year, and if you cash it during the first 5 years, you pay a penalty of 3-month's interest. That makes the I Bond a loser if inflation comes down.

If inflation stays up, you have to figure that interest rates will eventually follow. So far, there have been plenty of investors willing to take interest rates that are below the inflation rate, but that's an unusual situation--an odd confluence of foreign investors with large amounts of dollars that they have to put somewhere, combined with the credit crisis making people so nervous that they're willing to accept low rates in exchange for safety. I don't think that will persist, though--and in any scenario where interest rates move up above inflation, the I Bond is a loser again.

The only scenario where the I Bond is a winner is if inflation stays up but interest rates stay down. That's been true for months now, and it's always possible that it'll continue to be true. If it stays true for a year or more, then the I Bond will be a winner. To my mind, though, that's not the way to bet.

This is the culmination of a tend that's run throughout the Bush presidency. The last fixed rate set by the Clinton Treasury (in November of 2000) was 3.4%, and at that time the inflation part of the rate was just 1.52%. Under Bush, the inflation part of the rate has risen substantially, and the fixed part has shrunk to zero. Giving the small saver a good rate is simply not a priority for the Bush Treasury.

If you've got an old I Bond, bought when the fixed rate was higher, be sure to hang on to it--you've got a sweet return locked in for a long, long time.

[Update 3 November 2008: There's now a new rate for the next six months: 0.7%.]

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Savers suffering as rates fall--what to do

Philip Brewer — Fri, 04 Apr 2008 13:33:36 +0000

Interest rates for ordinary savers held up pretty well after the first Fed rate cut in July last year. There was a simple reason--banks needed the money. With the credit squeeze making it tough for banks to raise cash, the last thing they wanted was for savers to draw their money out in search of higher returns. The Fed's efforts to relieve the squeeze have been somewhat successful--banks have substantially cut the rates they'll pay savers.

The first graph shows the Effective Fed Funds Rate (blue) versus the rate that I've been earning on my ING Direct savings account (red). (I picked the ING rate simply because it's one that I happened to have data for. The Fed Funds and mortgage rate data are from the St. Louis Federal Reserve.) As you can see, the savings account rate held steady for a couple of months after the Fed Funds began to drop, and even after it began to fall, fell more slowly.

The rates actually crossed over in December, with the Fed Funds rate falling below the savings account rate.

Still, with the Fed driving rates lower and lower, the rate paid to savers dropped steadily. The 4.5% that ING was paying last summer has fallen to 3%.

As an aside, it's worth noting that the rates that bank charge have scarcely dropped at all. The green line tracks the average rate for a 30-year conventional mortgage, which has barely budged over the past year.

Given this, what's a saver to do? Well, shopping around for better rates is always worth doing. There are banks paying more than ING Direct. It's also worth considering other savings instruments.

As an example of the latter, consider savings bonds, and in particular, the I Bond. It pays a complex variable rate based on the Consumer Price Index. Some people dismiss it, knowing that the CPI substantially understates inflation. That's a mistake. Instead of comparing the I Bond to the inflation rate, you need to compare it to other rates available to savers.

The way the I Bond works, there's a fixed rate to which is added an inflation rate (basically, the CPI). The fixed part doesn't change once you buy your bond; for the rest of this month, it's going to be 1.2%. The inflation rate changes every six months, based on the CPI for the preceding six months.

We know what the combined rate is for the rest of this month: 4.28%. If you buy a bond this month, you'll keep the same 1.2% fixed rate for the lifetime of the bond. We also know that the growth in the CPI for the past six months will almost certainly be as high as the growth in the preceding six months, so you can be reasonably confident of getting as good a rate for the next six months as you're getting for the first month. After that, rates will vary--but I don't think you need to worry about the rate of growth in the CPI dropping so low as to make an I Bond uncompetitive with an ordinary CD or savings account any time soon.

So, how do I Bonds stack up compared to CDs or savings accounts? Well, one big difference is that you can't get your money back for a year. Once a year has passed, you can cash your bond in any time you want, but if you cash it in before 5 years are up, you lose 3 months interest. Taking that penalty into account, an I Bond is roughly as good as a 1-year CD that pays 3¼%.

The big win for I Bonds comes when you really don't know how soon you might need the money. You have to be confident that you won't need the money for a year, but after that you can decide month-to-month whether the I Bond is the best choice. If those months add up to 5 years, the 3-month interest rate penalty goes away and the bond just gets better.

Because you don't know the future (regarding either interest rates or your future needs for money), one thing to consider with savings bonds is buying them in small amounts over time. You can buy an I Bond for as little as $50 ($25 if you buy them electronically via TreasuryDirect). That makes it easy to manage the one-year wait before you can cash a bond in--buy very modest amounts at first. If the interest rate remains competitive, buy more later.

Two other details:

There's a special tax provision that lets you defer taxes on savings bond interest until you cash the bond in. (And, like any US government security, the interest is free from state income taxes.)
Savings bonds pay interest from the first of the month, no matter when in the month you buy them. So, by buying them near the end of the month, you can pick up almost one month's interest immediately.

If you're struggling to find a reasonable return for your savings, and you've got some money that you can safely tie up for a year--especially if there's a pretty good chance that you won't need it for another five years--the I Bond is a reasonable choice. It's quite a bit better than most bank CDs.

Update: As I feared, this deal was too good to last. On May 1st, the Treasury announced the new fixed rate for the next six months: Zero

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: