Savings bonds have been around for many decades and have continued to be a popular investment because of their safety. The most recent savings bonds are classified as E Bonds, EE Bonds, H Bonds, HH Bonds and I Bonds. This article will provide a brief overview of the characteristics of each of these types of bonds.
Savings bonds can only be purchased directly from a bank or financial institution that is authorized to sell them on behalf of the government. They also can be purchased online at www.treasurydirect.gov. Likewise, savings bonds can only be redeemed through these authorized institutions and cannot be traded with other investors, as there is no secondary market for them.
Savings bonds are taxed at the federal level, but not at the state level, and the owner can choose when to pay the tax. They can pay the tax each year as the interest accumulates or they can let the taxes defer (except for H or HH Bonds) until they cash in the bond at a later date which is the option that is selected by most bond holders. Additionally, for bond holders who elect to defer their taxes, the IRS requires that the interest be reported no later than the year the bond reaches its final maturity.
E Bonds
E bonds were originally issued in 1941 and earned interest for 30 to 40 years depending on when they were purchased. They are no longer available for purchase today, and although there are still a few that are continuing to accrue interest, the last of the E Bonds, which were issued between June and October 1979, will quit accruing interest in 2010.
E Bonds were originally sold at a price equal to 75% of the face amount which ranged from $25 to $10,000. Therefore, an E Bond with a face amount of $100 would be sold for $75. As it continued to accrue interest, its value would eventually surpass the face amount until it matured. Most E Bonds have either been redeemed or converted into EE Bonds which are described below.
EE Bonds (Double E Bonds)
EE Bonds were introduced in 1980 to replace the E Bonds and can be purchased in paper form or electronically. These bonds are purchased at a 50% discount from their face value if they are purchased in paper form, which range from $50 to $10,000, and at their face value if they are purchased electronically. Additionally, there is a maximum purchase limit of $5,000 per year per social security number.
The interest paid by these bonds is determined by when the bond was purchased. There are some EE Bonds that have paid and/or are currently paying a fixed rate of interest that may be guaranteed for a few years to twenty years. There are other EE Bonds in which the interest fluctuates based on current market conditions. There are still others that are issued with a fixed interest rate initially and then revert to a fluctuating rate after a period of time, such as five years.
When an EE Bond is issued, it has an original maturity date which ranges anywhere from eight years to twenty years depending on when it was issued. After this initial maturity, these bonds will continue to earn interest for a maximum of thirty years.
Additionally, the tax may be avoidable if the owner uses the funds to pay for qualified higher educational expenses. There are certain conditions that need to be met, namely, the bond and the qualified expense must be incurred in the same year. If these conditions are met, the accrued bond interest could be tax-free.
H Bonds
H Bonds existed from 1952 to 1979 and were referred to as income bonds and are no longer in existence. Unlike the E Bond that would accrue interest and then be cashed in at a later date for a higher amount, the H Bond would be purchased for the face amount and then make an interest payment to the investor every six months. The maturity of H Bonds depended on when they were purchased and had a maximum maturity of 30 years.
HH Bonds
HH Bonds, which were offered from 1980 to 2004, were developed to replace the H Bond. The primary difference is that you could not purchase an HH Bond directly as the only way to acquire them would be in exchange for an E or EE Bond. As with H Bonds, HH Bonds were acquired at face value and then made an interest payment to the owner every six months. Additionally, HH Bonds have a maximum maturity of twenty years.
One of the primary advantages of HH Bonds was that it offered the ability to continue the tax deferral that had accumulated in the E or EE Bonds. As noted earlier, most E or EE Bond owners would allow the interest to accumulate tax deferred for as long as thirty years which resulted in sizable gains. If the bonds were cashed in, the tax on the gains would be due immediately whereas if the proceeds were converted into an HH Bond, the tax on the growth could continue being deferred, possibly for another twenty years. However, even though the taxes on the gains could be deferred, the interest paid by the HH Bond is taxable in the year it is received.
I Bonds
I Bonds are savings bonds that are designed to provide an inflation hedge. These bonds are issued in denominations that range from $50 to $5,000. I Bonds are purchased at their face value and will accumulate in value, as opposed to making periodic interest payments, for a maximum of 30 years. There is a $5,000 maximum investment per year which makes them less than ideal for larger investments. Although you must hold them for at least twelve months, if you redeem an I Bond during the first five years, you will forfeit the last three months of interest.
When an I Bond is issued, it has two different interest components. The first component is the fixed rate, and like most bonds, the fixed rate will remain constant throughout the life of the bond. The second component is the inflationary hedge, which adjusts the rate of return every six months. The inflationary aspect of the I Bond is determined by the last six months of the CPI (consumer price index).
In determining the interest rate that an I Bond will pay for the following six months, there is a formula that takes into consideration both the fixed rate of interest along with the CPI inflation rate for the last six months. The result of this formula is known as the composite rate and this is the rate of interest that the I Bond will earn for the following six months.
If inflation, as measured by the CPI, is higher than the fixed rate, the interest that will be added to the bond will also be higher than the fixed rate. Conversely, if the composite rate is lower than the fixed rate, the bond will receive a credit of less than the fixed rate for the following six months.
In a six-month period with no inflation, the I Bond will earn the fixed rate of return for that period. In a deflationary period with a negative CPI, one would conclude that the I Bond would have a negative rate of return and lose value. However, the government has promised investors that they would never lose money on a government bond. Therefore, the worst case scenario for any six-month period would be a zero percent return, but keep in mind that you may not earn even the fixed rate of return in a period of deflation.
Additionally, the tax may be avoidable if the owner uses the funds to pay for qualified higher educational expenses. There are certain conditions that need to be met, namely, that the bond and the qualified expense must be incurred in the same year. If these conditions are met, the accrued bond interest could be tax-free.
To learn more about a particular bond, visit www.treasurydirect.com.
