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Savings Bonds: What are they and How Do they work?

Saving money for the raining days or for the future is one thing everyone considers but the problem is saving it where you are sure you will get it whenever you need it (especially for a long period of time). This is where savings bonds top the chart. A savings bond is considered a super safe way to save money for many reasons. One of these reasons is that it’s backed by the full faith and credit of the U.S. federal government. But what is a savings bond, how does savings bonds works, what are the various types of saving bonds, how can one determine savings bonds rates, or savings bonds interest rates? We are going to give you precise answers to these questions and more….

 

What is a Savings Bond?

A savings bond (U.S. savings bonds) is one of the world's safest investment savings, backed by the U.S. Government. It is a type of government debt or security issued by the U.S. Department of Treasury through the Bureau of the Public Debt at a relatively low investment return. Savings bonds help the U.S. government to raise finances to pay off its debts.

Savings bonds are also known as non-marketable securities. This is to say you cannot buy or sell this bond type unless you are a licensed issuing and redeeming agent authorized by the U.S. Treasury Department. There are registered securities, because it is restricted to the person or persons whose named is/are on the bond or who owns them.

Savings bonds are typically issued for long terms (up to 30 years), over a fixed amount of interest throughout the term. Once the term expires, the issuing government agency (government treasury), pays off the bondholders and retires the debt. Savings bonds usually sell at a face value of $50, $100 or $1,000 each, but purchased is allowed only in blocks of five or ten.

 

Who can purchase Savings Bonds?

U.S. savings bonds can be owned by almost every U.S. citizen, private and public organizations, corporations, fiduciaries, and associations. However, there are some criteria that must be met.

  • The individuals or organizations must be a resident of the U.S. However, citizens of the U. S but living abroad must have a recorded U.S. address
  • Civilian employee of the U.S. (no matter their residence)
  • A minor, unlike many other securities and investments, minors can legally own U.S. savings bonds.

 

Advantages of Savings Bonds

Safe: Savings bonds have the full backing of the U.S. Government, and since the U.S. government is very unlikely to fail or default payment, thus it is known as one of the safest means of saving money for future use. The government will even replace your savings bonds even if you lose them, especially if you are able to provide your bonds information, such as issuance date, address and social security number of the bearer, and the serial number.

Accessibility: This bond type can actually be purchased by almost any investor, which makes it very accessible. Investing in savings bonds required as little as $25 with the possibility of getting a multiple of it. For example, you can buy a $50 Series EE savings bonds for as low as $25 and after 20 years (at maturity), you can redeem it for $50. For this reason, savings bonds are considered good gifts for children planning a attend college.

Tax shelter: Investing in savings bonds can be viewed as a means to provide tax shelter for your earnings since you are exempted from paying income tax on the earnings of Series EE savings bonds until you redeem them. Also, savings bonds are easy to get from a variety of sources.

Inflation index: Savings bonds may provide a reasonable, steady investment growth and an inflation-indexed return for the long term.

 

How Does Savings Bonds Works?

A savings bond is a form of financial obligation, issued by a corporation or a government agency. Savings bonds are interest-bearing certificate that is issued for a specific purpose. These purposes may include college fee, making capital improvements, purchasing equipment or real estate, refinancing existing debt, or acquiring other businesses. There are mainly intended to be long-term (5, 10, 20 or even 30 years) investments.

The working of the savings bond can be likened to you loaning money to the US Treasury, with the promise they will repay it after a certain period together with a small increase known as the savings bond interest rate.

After this set period, the savings bonds are eventually ready to be redeemed. The easiest way to redeem savings bonds is via your credit union, local bank, or other financial institution. You can also redeem it by contacting the nearest Federal Reserve Bank or the U.S. Bureau of Public Debt.

The process of redeeming savings bonds at any financial institution is simple, easy and straightforward. All you need is to make available any official identification document (such as a driver’s license). In case you are not the owner (after the death of the bond owner, you will need to show a death certificate and any document that entrusts you as the next of kin) of the bonds, you will be required to show proof that you're entitled to redeem them. You can also cash the bonds for your children. In which case, a request to cash the bond may have to be sent to the Federal Reserve Bank (this can easily be done through your financial institution).

You can redeem all your savings bonds or for its full value, once you have held them for more than 5 years. If it’s less than 5 years, there is a penalty that is typically equaling three months' interest. For instance, if you redeemed a savings bond that you had held for just 2 years, you would receive bonds interest for 21 months, not 24 months.

 

Types of Savings Bonds

There are generally two types of savings bonds available in the U.S. today. The various types of savings bonds (series EE and I bonds) can be distinguished by the ways in which interest is paid on them.

Series EE Bonds

This is the most common type of savings bonds. They can be purchased directly from the Treasury or from other financial institutions (banks, credit unions, etc.) at a discount to their face value (that is, you pay $50 for a $100 bond), and are issued on a fixed monthly interest rate based on the rate at the time it was issued. This savings bond type matured after 20 years, a period which the U.S. Treasury can guarantee that investors must have doubled their money.

This is to say that, if for example you buy a $100 savings bond for $50 in 2010, you will be able to redeem it for an amount not less than $100 in 2030.

However, there are a number of considerations

  • You can redeem a Series EE bond after being held for just a year.
  • If you cash a Series EE bond before its 5 years old, you will incur a fine of 3 months' interest.
  • When the Series EE bond matures (20 years after) and it’s not redeemed, the U.S. Treasury resets the interest rate, and extends the maturity by 10 more years.
  • At maturity, when you redeem a series EE bonds, you receive the face value plus the accrued interest.
  • Savings bonds are not subject to state and local taxes but are subject to federal income tax. You only pay such tax only after redeeming your bonds.
  • When held a series EE bond until 20 years after purchase (maturity), you are guaranteed to double its value. The effective yield is 3.5%. This benefit is not the same for the series I Bonds. However, there is a possibility to receive more than double your purchased amount with the series I bonds

Potential returns
Savings bonds interest rates are typically lower (about 0.1%). This is to say, series EE bonds issued from Nov. 1, 2014 to April 30, 2015 receives savings bonds rates of 0.1%. But, if you keep the bond to its maturity (after 20-years), your return will increase considerably to the savings bonds rates of return of approximately 3.5% per year. The interest is compounded at the end of 20 years. This is due to the fact that, the U.S. Treasury guarantees that all investments in a Series EE bond type will double in value after being held for 20 years or its maturity.

 

Series I Bonds

These are also safe or low risk savings just like the series EE bonds. However, they both earn different savings bond interest rates.  The series I bond has both fixed and variable rates. These rates are set with respect to the current inflation rates.

The fixed part of the interest remains unchanged throughout the life of the bond. The variable or inflation half of the interest is reset every 6 months. For instance, a series I bond could have a 1.1% fixed interest rate and a 2.5% inflation rate. In which situation, the savings bond interest rate would be 3.6% annually, until the inflation part is reset.

However, this may not always be the case. When, for example, there is deflation (negative inflation), this will result in a negative inflation component. When this happened, the combined rate would be below the 1% fixed rate half. That notwithstanding, the combined interest rate is not allowed to go below zero.

Series I bonds are sold at their face value or half their full value starting with a minimum denomination of $50. This is to say you will buy a series I bond worth $100 for just $50. At maturity, you redeem this bond for $100 plus interest incurred. Other denominations are $75, $100, $200, up to $10,000 (the maximum).

Savings bonds allow people with limited resources as a means to start an investment plan. The U.S. government offers Series EE bonds at one half their face values, which ranges from $25 to $10,000. At maturity (20 years after purchase date), you can redeem the bonds at their face value. You may buy up to a face value maximum of $30,000 in Series EE bonds annually for a maximum period of 30 years.

You can use the two types of savings bonds in different ways. For example, you can use them as a very safe instrument that provides stability to your investment portfolio and as a regular savings program through payroll deductions. Because of the small amount of investment ($25) require, savings bonds offer people with limited resources a better means to start an investment program.

 

Disadvantages of Saving Bonds

Just like most investment, savings bonds have some pitfalls. One of the downsides being, the period or duration needed to get to maturity. It takes at least 20 years for a savings bond to mature. This means, if you are not able to wait that long, then investing in savings bonds can be disadvantageous to you.

If you redeem your savings bonds before it reaches 5 years, you will require paying a penalty which is at least 3 months interest. This is not only the problem, you will also receive bond payments for which the interest rate is set as low as 0.1%

Again, unlike stocks where you can sell it to almost anybody who can afford the price, you cannot by law, sale out your savings bonds to someone else. You can only redeem savings bonds with the U.S. Treasury. You will only be allowed to redeem a savings bond when it has been held for at least 1 year (12 months). 

 

Buying US Savings Bonds

It was not until January 2012, that all forms of paper savings bonds were discontinued and are no longer available. Therefore, the only available way to buy savings bonds today is electronically via TresuryDirect.gov (the U.S. Treasury website).

In order to be able to purchase savings bonds, you shall be required to set-up an account. The different types of savings bonds can only be bought directly from the U.S. Treasury (there are no commissions to pay to a broker when purchasing US savings bonds. However, there is a maximum amount of savings bonds that can be purchased each year, in any denomination, starting at $25. You are allowed to purchase up to $10,000 per bond type and for every social security number per year. A married couple (who are without children) can purchase up to $20,000 worth of series EE bonds and $20,000 worth of series I Bonds in a single calendar year.

Buying Savings Bonds Using Payroll Saving Plan

You can also buy savings bonds using a payroll saving plan. This plan allows employees to purchase savings bonds in different denominations of their choice. Once you determine the denomination, the amount of money you signed in your payroll saving plan will be automatically deducted from your paycheck and be directed to buying both series EE and I savings bonds. This plan can stand alone or be combined with any existing retirement investment plan like the 401 (k). A payroll saving plan is easy to set up and currently has over than 45,000 users. Once you activate your plan, savings bonds will be purchased for you, and this will continue until when you leave your PLACE OF employment or when a written notice is received from you.

 

Series EE and Series I Bonds, Which is Better?

Series I bonds are typically considered to performs better than series EE bonds. Its only downside is that, during periods of economic crisis and deflation, they could earn very small interest. Such is the case of the recent recession which saw the variable interest rate far below the fixed savings bond interest rates. This resulted in a 0% yield for series I bonds.

 

How much can you earn from Savings Bonds?

The bottom line of all investments is growth or interest. You want your money to work for you. However, the returns on savings bonds is relatively low, when compared to other forms of investments, but it’s also super safe since it has the backings of the U.S. government.

The savings bonds rates are announced twice a year (every 6 months) and take effect May 1 and November 1. If savings bonds last five years, the Series EE bonds are redeemed for 90% of the six-month average growth at five-year Treasury securities. Earnings may vary for EE bonds bought from 1980 to 1997. If you hold these bonds, we advise you to consult the Bureau of Public Debt for exact figures or your financial institution. Many Series E bonds have discontinued paying interest. Thus, when you redeem your bonds, you receive the interest earned together with your principal.

Series I bonds purchased between November 1, 2008 and April 30, 2009 will be calculated with a 5.64% interest for the first six months. This 5.6% rate is a combination of a 0.7% fixed rate (fixed for the life of the bond) and an adjustable or variable rate (adjusted six months) based on inflation. When you redeem your bonds, you will receive your principal together with the interest earned. The U.S. government developed the Series I bonds as a means to provide investors a rate of return above inflation.

 

Taxes that apply to Earnings from Savings Bonds

It is of great interest for investors to recognize the various taxes that may be applicable to savings bonds. Savings bonds are generally low interest earning investment, however, the low savings bonds rates are often compensated by favorable tax terms.

Savings bond’s earnings are generally exempted from the state and local taxes, but subjected to federal taxes. You may be allowed to defer payment of taxes on savings bonds for long periods.

Note that, the money you do not spend on taxes to purchase an item you want or to invest in other instruments.

If you purchase savings bonds (Series EE or Series I bonds) in the name of your child, and happen redeem it while the child is still a dependent, you will be required to pay taxes on the earnings at the child's rate. Such rate may be 0% (when the child's total income is not greater than $850, in whatever case, the child’s interest rate is probably lower than your tax rate.

The U.S. Treasury Department established an Education Bond Program in 1990. This program’s main goal is to exempt savings bond earnings from federal tax, if the bonds are redeemed to cover up for qualified education expenses. In order to be considered for this program, you must be at least 24 years at the time you are purchasing the bonds. You are also expected to redeem your bonds and document the tuition and certain education-related expenses. Expenses such as books, board, and room are not considered. If, however, the redeemed value of the bonds is greater than the qualified expenses, you will be required to pay federal taxes only on the extra portion and not for the fraction used for qualified expenses.

A full exclusion is also available to single taxpayers who have a lower than $78,100 annual income and married couples filing jointly with total income less than $124,700.

The tax benefits of savings bonds usually do cover up for their generally low returns. This way, savings bonds can be a part of a valuable portion of your investment portfolio.

Conclusion

Series HH bonds are no longer traded and have been discontinue in the list of US savings bonds. At this point, we are confidences you are able to say what is a savings bond, and how does savings bonds works. Savings bond interest rates may be lower when compared to other types of bonds, but it’s still one other the safest bond types to invest in, with a 100% guarantee, (backed by U.S. government), that you will get your bonds redeem upon maturity. However, a savings bond is a long term investment, therefore, you should be ready to wait about 20 years (maturity) to have the best from your savings bonds. These bonds are exempted from local and state taxes. You may only pay federal taxes on the earning from savings bonds. 

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