By George M. Hiller, JD, LLM, MBA, CFP®
Most money market funds at banks and brokerage houses pay less than 1% interest. In taxable accounts this interest is subject to federal and state income taxes each year. Almost everyone would like to earn more than 1% without appreciable risk and without current federal or state income taxes, but how can this be done?
The answer is by investing in two particular kinds of U.S. Savings Bonds, Series EE and I Bonds. These investments are suitable for individuals that seek higher interest returns with extremely low risk and for those who may want to build low risk emergency funds, retirement capital, education funds, or to make gifts to children.
Series EE bonds pay a market rate of interest that is based on 90% of the 6-month average of 5-year Treasury security yields. The current rate of interest is 2.61% as of November 1, 2003 until April 30, 2004. Chances are good that this may be double or triple the rate you are currently earning on your bank account, savings account, or money market fund. New rates are published every 6 months in May and November of each year.
Series I bonds are inflation-indexed bonds. They earn interest that is designed to be protected from inflation. The interest earned on Series I bonds is based on two rates. The first rate is a fixed rate of return that is established at the time of purchase. The second rate is a semiannual inflation rate that is calculated based on changes in the consumer price index – urban (CPI-U), a statistic that is designed to measure inflation. The rate you get paid is the fixed rate plus the semiannual inflation rate. The current rate of interest on I bonds is 2.19% as of November 1, 2003 until April 30, 2004. New rates are published every 6 months in May and November of each year.
Series EE and I bonds can typically be bought at your local bank, but they can also be bought in paperless form directly from the U.S. Treasury by opening an account over the Internet at www.treasurydirect.gov. When buying through TreasuryDirect the minimum purchase for each kind of bond is $25 and the maximum purchase is $30,000 per person per year. An individual could buy up to $30,000 Series EE and $30,000 Series I for a total of $60,000 per year. Purchases are made by electronic debit from your checking or savings account.
Series EE and I bonds have a minimum term of ownership of 12 months. This means that you can not redeem the bonds in the first year of purchase. After 12 months the bonds are redeemable at any time, but redemptions prior to 5 years are subject to a small penalty. The early redemption penalty for bonds redeemed within 5 years of purchase is loss of the 3 most recent months’ interest earned. After 5 years there is no penalty to redeem bonds. Even if you redeem within 5 years and incur the small penalty, the interest you earn is likely to be far more than what you would have earned in your money market fund.
Interest earned on Series EE and I bonds is subject to federal income tax, but not until the bonds are redeemed. This allows for deferral of federal income tax up to the maturity date of the bonds, that is 30 years. If you redeem the bonds prior to maturity, the interest will be subject to federal income tax in the year of redemption. It is also significant to note that interest earned on Series EE and I bonds is not ever subject to state income tax.
U.S. Savings Bonds are backed by the full faith and credit of the U.S. government. As such, they are among the safest investments in the world that a person can make. If you have money or savings that is earning less than 1% or 2%, and you want to earn more without any increase in risk, and you will not need the money for one year or longer, then you should consider investing in U.S. Savings Series EE or Series I bonds.