Savings Bonds: The Key Facts You Need to Know

By Markets Fool.com

Savings bonds have long been a tool for savers to sock away money for the future without having to worry that they won't be repaid, as savings bonds are backed by the full faith and credit of the U.S. government. While interest rates are currently low, savings bonds are still a valuable tool for those who want to save money for at least 20 years into the future.

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Let's go over the key facts about savings bonds and Treasury bonds, how to buy savings bonds, and some other ways to save money.

Savings bonds and Treasury bonds
In common usage, savings bonds and Treasury bonds are interchangeable. Both refer to bonds issued by the U.S. Treasury to pay for the government's spending. But in reality, they are separate financial products offered by the U.S. government, and they have some important differences.

Treasury bonds pay a fixed rate of interest over their lifetimes, which range from four weeks to 30 years. Some pay interest semiannually, while others pay interest at maturity. All Treasury bonds can be bought and sold on secondary markets, and you can buy as much as you would like.

Savings bonds, on the hand, have a lifetime of 30 years, are purchased online directly from the Treasury and can only be redeemed by selling them back to the Treasury. Savings bonds are purchased at their face value but do not pay coupon payments; they accrue interest until they mature or are redeemed. As such, your federal taxes on the savings bonds' interest are deferred until you redeem them. You can avoid all federal taxes on the bonds if the redemption proceeds are used for qualified higher-education expenses.

Savings bonds have the added benefit that you never pay state or local taxes on the interest. The downside of savings bonds is that they pay low rates, which we'll get to in a moment. Savings bonds currently come in two varieties:

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  • Series EE Savings Bonds issued May 2005 and after earn a fixed rate of interest.
  • Series I Savings Bonds earn a variable rate of return based on the inflation rate.

It's important to note that you can only buy $10,000 worth of each series of savings bonds per year. You must wait at least 12 months after purchasing savings bonds to redeem them, and there is a penalty of three months' interest if you redeem your savings bonds within five years of purchasing them.

Now on to the two types of savings bonds.

Series EE Savings Bonds
Series EE Savings Bonds are purchased at their face value and mature in 30 years. Series EE Savings Bonds earn an annual interest rate of just 0.1% face value of the bonds, which compounds semiannually. With such a low interest rate, why would anyone purchase savings bonds?

The Treasury guarantees that an EE Savings Bond will be worth at least double its purchase price after 20 years. If the savings bond is not worth double its purchase price, the treasury will make a one-time adjustment on the 20-year anniversary of the bond's issue date to make up the difference. So after 19.5 years, a $50 EE Savings Bond will only be worth $50.98 for a cumulative return of 1.96%. But at the 20-year anniversary the bond will be worth $100, for a cumulative return of 100%, or a compound annual return of 3.5% over the 20 years.

Series I Savings BondsSeries I Savings Bonds are purchased at their face value online from the Treasury and mature in 30 years. While you haven't been able to purchase paper versions of the Series EE Savings Bonds since 2012, you can purchase up to $5,000 of the paper version of Series I Savings Bonds with your tax refund -- even on top of the $10,000 worth of electronic I Bonds you can purchase each year.

Series I Bonds pay a fixed rate of interest, as well as a variable interest rate based on an inflation rate (the Consumer Price Index for all Urban Consumers). It's important to note that there is no 20-year kicker for Series I savings bonds. The fixed rate on series I savings bonds is currently 0%, while the semiannual inflation rate is 0.74% for a current composite annual rate of 1.48%. The fixed rate remains the same throughout the life of the bond, but the inflation rate resets every six months.

If you're looking for a savings bond to hold for less than 20 years, the Series I bond is certainly for you. The Series I Bond will also do better than the Series EE bonds over 20 years if inflation picks up to more than 3.5%.

Saving versus investing
Savings bonds are just one tax-advantaged way the government offers to help you save money for the future. It is important to take advantage of other savings tools such as retirement accounts, tax credits, tax deductions, and other ways to lower your tax bill, which will all help you keep more of your hard-earned money over time.

Saving money toward your goals is important, but if you have a time horizon of more than five years, you're better off investing your money into higher-earning assets. While these will certainly fluctuate more than savings bonds, the earnings potential is far higher than the meager 0.1% a savings bond offers.

The article Savings Bonds: The Key Facts You Need to Know originally appeared on Fool.com.

Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog where he writes about investing, happiness, the secret to success in life, what is success to you, the best business books of all time, the NY Lottery, and the Fortune 500. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.