Why I Like Savings Bonds

Why I Like Savings Bonds

Several people have asked why I like Series I savings bonds, so I thought I’d address that with a dedicated post…

For context, the Treasury has recently announced that they’re (mostly) getting rid of paper savings bonds, which effectively cuts the annual purchase limit in half (from $5k paper + $5k electronic to just $5k electronic). While you can work around this limitation by buying savings bonds with your tax refund, that’s a bit of a hassle.

Inflation protection

For starters, I bonds offer a degree of inflation protection, as their rate (updated every May and November) is partially pegged to the CPI. The rate is actually made up of two components – a variable rate calculated from changes in the CPI and a fixed rate that represents a premium over inflation.

Recently, the fixed rate has been pegged at 0%, which means that you have to depend on that variable rate to generate your return. In other words, your “real” (inflation adjusted) return is 0% before taxes. Not great, but at least you’re not lagging behind inflation, as you would if you stuck your money in a savings account.

Tax treatment

Another nice feature of savings bonds (both I and EE bonds) is that the interest is exempt from both state and local taxes, and federal taxes aren’t due until the bonds are redeemed. Thus, savings bonds give you an IRA-like tax deferral in addition to existing IRA contribution limits.

And guess what? If you use your bond proceeds to pay for college, the interest income will ultimately be tax free (subject to restrictions; details). Thus, they can be a nice complement to things like a 529 plan.

Effectively higher rates

A common criticism of I bonds is that, due to the low (currently zero) fixed rate, you’re guaranteed to lose to inflation after taxes, even with the state and local tax exemption. As I’ve noted above, this isn’t entirely true, as you can use the proceeds to pay for college and get a federal tax exemption.

To crystallize the above points, let’s take a look at the tax equivalent yield of current I bonds. As of May 2011, the variable rate stands at 4.6%. Compared to available savings and CD rates, this is quite high. Sure, it might drop in the future, but only if inflation likewise declines.

So what about the tax equivalent yield? The tax equivalent yield of an investment is the rate that you would have to earn in a fully taxable investment to equal the return that you’re getting in a tax-advantaged investment. You calculate it by dividing the rate of the latter by one minus the tax rate, as follows:

Tax Equivalent Yield = Tax-Free Yield / (1 – (% Tax Bracket / 100))

Assuming that you live in a state with a 6% income tax rate, which is a fairly middle-of-the-road value, your tax equivalent yield on a current I bond would be roughly 4.9% – not too shabby. But wait! What if you’re planning on using it to pay for college, and you’re in the 25% tax bracket? In that case, (25% federal + 6% state) your tax equivalent yield would increase to nearly 6.7%!

Yes, your rates will bob up and down every six months, but it’s hard to argue with those sorts of numbers given the current interest rate landscape. Of course, if you live in a state with no income tax, the numbers will change, but that federal exemption is still a big deal.

Reasonable redemption policies

Finally, we have to consider getting your money back out… Sure, you’ll get better-than-bank interest rates, but what good is that if you can’t access your money? There’s good news and bad news here. For starters, you can’t redeem your savings bonds during the first 12 months. Period.

Once 12 months has passed, however, you can redeem for a 90 day interest penalty. And this penalty could be very low if you do it during a period of low inflation (when rates are at their lowest). After five years, the penalty goes away entirely.

So there you have it… We like Series I savings bonds for the combination of inflation protection and tax advantages – and the accompanying boost in terms of tax equivalent yield. They’re not sexy, and they’re not exciting, but they are a valuable part of our portfolio.

6 Responses to “Why I Like Savings Bonds”

  1. Nickel

    We won’t know until probably October, when the rate can be calculated from the then-current inflation numbers. No idea on when the fixed rate will increase, but even when it starts happening it seems likely (at least to me) that it will be incremental – may 0.1% at a time.

    So if you bought I bonds right now, you’d get 4.6% for the next six months, and then the new rate for the six months after that, at which point you could break the bond for a 90 day interest penalty. Assuming that the next rate is similar to the current (hard to say if this is anywhere near true) then you could earn 4.6% for the next year, give back 25% of that, and still come out well ahead of your checking account – not to mention that the earnings are exempt from state and local taxes no matter what.

    Worth it? That’s up to you. But keep in mind that you can only buy a limited amount of savings bonds per year, so it’s not like you can just wait for the rate to increase and then load up on a ton of them at that time. And with the loss of paper bonds, the limit will be half what it is right now (unless you want to jump through the tax refund hoop).

  2. Anonymous

    Currently my money is in a high yield checking earning 2.75%. Do you have idea what the variable rate will be come November? Do you have any guesses on how long it will be before the fixed rate increases?

  3. Nickel

    Steve: I’m not waving it away. In fact, I ran the numbers for the state/local exemption along. And to be fair, I did title the article “Why *I* Like Savings Bonds” (emphasis added), not “Why You Should Like Savings Bonds.” 😉

  4. Nickel

    Ginger: What are you doing with your money in the mean time? You can’t get an essentially no-risk return like this anywhere. There’s an opportunity cost to waiting, and my guess is that you’ll be waiting a long time to get a fixed rate anywhere near 0.5%.

  5. Anonymous

    You can’t just wave away the tax issue. Not everyone happens to have education expenses in their future.

    That said, your point that rates on normal savings/bonds are so low right now, is a good one.

  6. Anonymous

    As soon as they raise the fixed component, even to .50, I am buying a bunch. I know quite a few people who are waiting for the fixed portion to be raised before buying. I do wonder if the federal government would be better off raising the rate and having it’s debt owned by Americans and not by other countries. I cannot find anywhere what rates the US pays on the international market.

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