How Do Savings Bonds Work?

Savings bonds offer a super safe way to save money, but are they worth it? Here's how Series EE and Series I savings bonds work.

Apr 15, 2015 at 12:33PM

Savings bonds are one of the world's safest investments. Backed by the full faith of the U.S. Government, savings bonds offer a safe place to build savings for the long-term at the cost of a relatively low investment return.

There are two types of savings bonds issued by the U.S. government today. Here's how they work.

Series EE bonds

Series EE bonds are the most common type of savings bond. They're purchased at a discount to their face value, and accrue interest monthly based on a fixed rate at the time they are issued. The bonds mature after 20 years, at which point the U.S. Treasury will guarantee that investors have doubled their money.

Thus, if you buy a $50 savings bond for $25 in 2015, you will be able to redeem it for at least $50 in 2035.

Here are a few more important details:

  1. You can cash in a Series EE bond after it is 1 year old.
  2. If you redeem a Series EE bond before it is 5 years old, you will incur a penalty of 3 months' interest.
  3. When the bond matures 20 years after it is issued, the U.S. Treasury will reset the interest rate, and extend the maturity by 10 more years.
  4. Savings bonds are subject to

    federal income tax, but not state and local taxes.

Potential returns

Currently, savings bonds provide a tiny return -- Series EE bonds issued from Nov. 1, 2014 to April 30, 2015 pay an annual rate of just 0.1%. However, if you hold the bond to its 20-year maturity, your return will jump considerably to a compounded rate of return of roughly 3.5% per year. This is because the U.S. Treasury guarantees that an investment in a Series EE bond will double in value after 20 years.

This is best explained graphically. A Series EE bond purchased for $2,500 at the time of writing would be worth only $2,538 after 15 years. However, at maturity in year 20, the bond would be redeemable for $5,000. Thus, savings bonds purchased in a low-interest rate environment provide the best return when held to maturity, to take advantage of the minimum guaranteed return.

Series I bonds

Where Series EE bonds pay a fixed rate of interest, Series I bonds pay a variable rate of interest. The interest is calculated based on a fixed rate at the time of issue plus the recently calculated rate of inflation.

If you buy a Series I bond with a fixed rate of 0.1%, you will earn the fixed rate of 0.1% plus the inflation rate as calculated during 6-month intervals over the 30 year life of the bond. The fixed rate won't vary, but inflation rates will, resulting in a variable return.

Source: www.fool.com

Category: Personal Finance

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