I received a request last week: “I would like to see something concerning U.S. Savings Bonds on your segment. We have many that we can cash. What is the best way to avoid taxes?” One of our Associate Advisors, Reagan White, prepared this overview:
Savings Bonds have been around since the tail-end of The Great Depression and have been a great source of fund-raising for the U.S Government. In fact, these bonds were titled “War Bonds” in 1941 as America incentivized citizens to invest in the war effort! Over the years, there have been many forms and types of savings bonds that have been issued by the Federal Government, but the only bonds available today are EE Bonds and I-Bonds. Here’s the difference between the two:
Originally created to incentivize education savings (“EE” = Education), EE Bonds are issued with a fixed interest rate in dollar amounts as little as $50 with maturities up to 30 years! Investors will earn a yearly interest rate but will not receive any cash until the eventual maturity. While this is a negative for investors who need cash flow, it is a positive for those who want to defer taxation until later years (One note: investors can choose whether to be taxed on an annual basis or in the year of redemption/maturity, but most people elect to defer taxes until the bond is redeemed or matures).
These savings bonds are similar to EE bonds in almost every way except one: inflation (“I” = Inflation). I-Bonds were created to mitigate the effects of inflation on investors’ return. The way it works is that I-Bonds earn a small fixed percentage plus semi-annual interest increases in the amount of inflation growth (measured by CPI). This ensures that investors won’t lose purchasing power over the life of the bond.
While savings bonds offer great potential for tax deferred growth, they come with an expiration date, which brings a large tax bill on any of the earnings accumulated. While you must pay the tax in the year of maturity when you receive the principal plus earnings, investors can “redeem” their savings bonds prior to the year of maturity. Here are some things to consider in deciding whether to redeem your savings bonds or not:
If an investor redeems their savings bond within 5 years of buying it, they will have to pay a penalty of 3 months’ worth of interest. This is money left on the table and should be avoided.
- Education Savings
If you or your child have plans to go to college, then your savings bonds are a great source of capital! Both EE and I-Bond earnings will not be taxed if they are used for qualified education expenses at an eligible post-secondary education institution. Be careful here, because there are many qualifications to consider in order to have the earnings excluded from income.
If you are planning on redeeming your savings bonds, then timing can be crucial. If you can project what your income levels will be going forward (for example: when you retire), then you will definitely want to postpone redemption until a year of lower income. Though your savings bonds will be taxed based on ordinary income tax rates, your tax rate may be lower, which will limit the tax burden.
If your income is constant for the foreseeable future, then it’s best to look at the interest you are receiving from your savings bonds compared to interest you are paying on any outstanding debts such as credit cards, auto loans, store charges or mortgages. If the interest you are receiving on your savings bond is less than the interest you are paying on outstanding debt, then it may make sense to pay down the debt with your savings bonds. The difference between the two rates is a guaranteed rate of return!
- Compare Investment Returns
If you can receive a better “risk-free” return on your investment somewhere else, then consider redeeming the savings bonds you currently own and invest in a U.S. Treasury Note/ Bond. The 10-Year U.S Treasury is currently yielding 2.93%, while EE bonds are currently yielding 0.10% and I-Bonds yielding 2.52%. While these interest rate spreads seem appealing, you cannot discount the tax deferral attributes savings bonds offer that other debt instruments do not.
These tax strategies need to be taken with care. Please consult with your tax advisor and go to www.treasurydirect.gov for more information.