How Do Savings Bonds Work? Savings Bonds Explained
5-minute readSeptember 28, 2020
When you were a child, you probably had that aunt or grandparent who would give you savings bonds for your birthday.
“Oh, boy!” you would think to yourself as you opened your birthday card and saw what looked like money with a picture of Thomas Jefferson on it. “I’m going to go buy a rad, new Nintendo game, or a Super Soaker!”
Not so fast, hotshot. Aunt Eunice bought you a $50.00 savings bond. It won’t be worth $50.00 for another 10 to 18 years, depending on the average 5-year Treasury yield that she bought it at 6 months ago. All you need to know is that good-old Eunice paid $25.00 for something that will be worth as much as a nice dinner when you’re in college.
Savings bonds are still available these days, though gone are the days when you could purchase them from your local bank. Before we discuss the value of savings bonds as part of your financial picture, let’s make sure we all understand exactly what they are.
What Exactly Is A Savings Bond?
Perhaps you’ve heard of Liberty Bonds. They were originally intended to help the United States finance World War I. Investors purchased bonds and then the U.S. government paid them back with interest after the war was over. Essentially, investors loaned the government money to fight the war, and the government paid them back with interest after the war.
Savings bonds are a long-term savings instrument intended to be a lower-risk alternative or compliment to more volatile investments like stocks. You’re investing in the United States of America. Since savings bonds are backed by the full faith and credit of the federal government, they tend to be some of the most risk-adverse investments.
How Do Savings Bonds Work?
Until recently, you would purchase a savings bond for lower than its face value (e.g., a $50.00 bond for $25.00), and you would wait for the bond to mature and then cash it in for its full value. The timeline for the bond to mature was typically 17 to 20 years.
Today we purchase savings bonds for the full value and they accrue interest until you cash them in. Interest accrues monthly and compounds semi-annually for a period of up to 30 years. But you have to wait a period of at least 12 months before you cash them in. The longer you hold on to a savings bond (up to a maximum of 30 years), the more it is worth when you finally cash it in.
Types Of Savings Bonds
There are two types of savings bonds: EE Savings Bonds and I Savings Bonds. EE Savings Bonds purchased after May 2005, earn a fixed rate of interest for up to 30 years. When you purchase the bond, you know exactly what your fixed interest rate will be.
The U.S. Treasury announces the rate each May 1 and Nov. 1 for new EE bonds. For example, bonds purchased from May 1 through Oct. 31, 2019, will earn an annual rate of return of 0.10%.
An I Savings Bond earns interest by combining a fixed rate and an inflation rate. The fixed rate remains the same throughout the life of the bonds, while the calculations for the variable inflation rate occur twice a year.
The inflation rate is based off of the adjusted Consumer Price Index for All Urban Consumers (aka, the CPI-U), which measures the change in the price of a basket of goods and services purchased by urban consumers.
The rate of return for an I Savings Bond is 1.90%. This rate is for bonds purchased between May 1 through Oct. 31, 2019. This rate only applies for the first six months the bond holder owns the bond.
How To Cash In Savings Bonds
As of 2012, most U.S. savings bond purchase transactions occur online through Treasury Direct.gov. You create an account, enter payment account information and begin buying bonds. You can also buy a savings bond when filing your federal tax return.
You must hold savings bonds for a minimum of a year before you’re able to cash them in. If you cash them in before the first 5 years, you could lose the last 3 months of interest. For example, if you redeem your savings bond after 18 months, you will only receive 15 months of interest.
To redeem your bond you will first want to determine its value. If you have an electronic series EE or I bond, you can use TreasuryDirect to identify the current value of your bond. You’ll use the “Current Holdings” tab in your account to find the current value. For paper bonds, you can use the Savings Bond Calculator.
For redemption, you can log in to your TreasuryDirect account and follow the directions to redeem your bond. Generally, the cash transfers to your savings or checking account within 2 business days of the request.
If you have a paper bond, you can redeem it at most local financial institutions. You also have the option to cash them in by mailing them to the Treasury Retail Securities Services.
Keep in mind, all savings bond redemptions are subject to federal taxation on the interest- generated income. However, there are no local and state taxes required. If you choose to use your bonds to fund higher education expenses, tax benefits may apply.
Are Savings Bonds Worth The Investment?
On the surface, savings bonds may seem like the perfect investment. Savings bonds can help consumers protect their money against inflation and supplement their retirement income. However, there are some drawbacks to purchasing savings bonds.
With the minimal returns bonds provide, focusing on bonds alone can be devastating to your retirement portfolio. Bonds don’t earn the returns that you can realize from investing in the stock market. By solely relying on savings bonds alone, you’re limiting your investment growth needed to support your retirement.
If you’re nervous about investing your entire portfolio into stock, try investing a small portion into savings bonds. This will provide some stability to your portfolio and lower your exposure to risk. Some investors allocate 5% – 10% of their money into savings bonds because of the guaranteed return. Deciding to invest too much into savings bonds can hold you back from earning growth.
You may also want to consider alternative investments. Investing your money in high-yield CDs and savings accounts can minimize your risk and help you achieve a greater return than you would receive with a savings bond.
The Bottom Line
With a little research, you may be able to find low-risk investment alternatives that can give you a better rate of return than savings bonds. Savings bonds can be a great addition to a diversified portfolio. They can help you lower your risk exposure and keep some of your money safe.
If you’re unsure about how much you should invest in savings bonds, seek guidance from a financial professional. Financial professionals can help you identify your financial needs and assist in the development of an investment portfolio that will help you reach your financial goals.
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