Savings bonds, issued by the U.S. government, are a form of debt security that operates differently from conventional bonds. These bonds function as zero-coupon bonds, in that they only pay interest at the time of redemption by the holder, unlike regular bonds which pay interest periodically. Additionally, savings bonds are non-transferrable, distinguishing them from other bond types that can be sold to others.
If you are contemplating including savings bonds in your personal savings strategy, it is vital to grasp the mechanics of how these bonds operate.
Understanding Savings Bonds
A savings bond is a prevalent form of government bond that governments issue to secure funds from the public for their capital projects and other economic management activities. Essentially, when the government sells bonds, it is borrowing money from the public, which it agrees to pay back at a predetermined future date. In exchange for their capital, the government pays interest to the bondholders.
A significant advantage of savings bonds is that they are not susceptible to state or local income taxes, making them an attractive investment option for many. However, it is worth noting that these bonds are non-transferable and non-negotiable, making them difficult to sell or exchange.
History of the Savings Bond
In 1935, during the Great Depression, President Franklin D. Roosevelt signed legislation that allowed the U.S. Department of the Treasury to issue federally backed savings bonds, Series A. In 1941, the Series E bond was first issued to help finance World War II and were called Defensive Bonds. After the attack on Pearl Harbor, they were called War Savings Bonds, and the money invested in them went directly toward the war effort.
After the war ended, Americans were encouraged to purchase savings bonds, which provided a way for individuals and families to earn returns on their investments while enjoying the absolute guarantee of the United States government.
Features of Savings Bonds
- Non-Marketable: The U.S. savings bond was designed to be non-marketable, meaning that an investor can only purchase the bond directly from the U.S. government and cannot sell it to any other investor. The bond, in effect, cannot be transferred, as it represents a contract between the investor and the U.S. government. This direct relationship ensures that the U.S. savings bond does not fluctuate in value. Therefore, an investor would receive their original investment if they redeemed the bond. Furthermore, any lost or damaged savings bond certificate can be reissued or replaced, since the bond is registered with the government.
- Purchase: An investor can buy the bonds in penny increments with a minimum investment value of $25 and a maximum value of $10,000. A bond investor cannot buy more than $10,000 face value of U.S. savings bonds in a calendar year. U.S. savings bonds can only be purchased and redeemed electronically through the TreasuryDirect website administered by the government. The investor must open a TreasuryDirect account and provide a Social Security Number (SSN), checking or savings account, and email address.
- Interest payment: U.S. savings bonds are zero-coupon bonds that do not pay interest until they are redeemed or until the maturity date. The interest compounds semi-annually and accrues every year for 30 years. After a bond has been held for 30 years, it will no longer generate interest payments to the investor. An investor who purchases the bond at the end of the month will still receive the interest accrued for the entire month. Any interest paid at redemption or maturity date is issued electronically to the bondholder’s designated bank account.
- Early redemption: The time it takes for a bond to mature varies, but it is often between 15 and 30 years. A bondholder must wait at least 12 months after initial purchase before redeeming the savings bond, at which point they will receive the face value plus interest. Furthermore, investors who redeem the bonds within the first five years of purchase will forfeit the last three months’ interest as a penalty. However, redeeming a bond after holding it for five years does not incur any penalty.
- Tax consequences: The interest earned from savings bonds is exempt from state and local income taxes. However, federal taxes apply, but only in the year in which the bond matures, is redeemed, or after 30 years, when the bond stops earning interest. If the investor uses the proceeds from the bond redemption to pay tuition for higher education, they may be exempt from higher taxes.
Different types of savings bonds
U.S. savings bonds come in a three series, only two of which are still issued:
Series E bonds
The U.S. government first issued Series E bonds to fund itself during World War II, and it continued to sell them until 1980, when Series EE bonds superseded them. Series E bonds are no longer issued.
Series EE bonds
Series EE bonds were first issued in 1980 and continue to be issued today. These bonds pay a variable rate if issued from May 1997 to April 2005, or a fixed rate if issued in May 2005 or after.
Series I bonds
Series I bonds provide a greater level of protection against inflation than do Series EE bonds: They come with a combination of a guaranteed fixed rate and a variable inflation rate that is set twice a year, based on the consumer price index.
How to cash in savings bonds
Both Series EE and Series I bonds can be cashed in once they are a year old. If you cash in either series sooner than five years, you’ll lose the last three months of interest payments.
Both series of bonds earn interest for as long as 30 years. The longer you hold the bond, the more interest it accrues, but not beyond the 30-year limit.
Paper bonds can be redeemed at most bank or credit union branches, while electronic bonds can be cashed on the TreasuryDirect website, by signing into your account and following the instructions for redeeming the bond. The cash value of the bond will be credited to your checking or savings account within two business days of the redemption date.
A minimum $25 is required to redeeming an electronic bond. No limit typically exists for cashing paper bonds, but the bank cashing the bonds may impose a restriction on how much you can redeem at one time.
Are savings bonds worth it?
Advantages
- Savings bonds are issued directly by the Treasury and backed by full faith and credit of the U.S. government.
- Only federal income tax applies to savings bonds, not state or local taxes (unless your state has estate or inheritance taxes).
- Savings bonds can be used to pay for higher education expenses and thereby avoid paying taxes on some or all of the interest on the bonds. Details are on the TreasuryDirect website.
- Series I bonds offer some protection against inflation because the rate adjusts in response to changes in the consumer price index.
- Series EE bonds have a special feature: the Treasury guarantees that an electronic EE bond issued in June 2003 or later can be redeemed for at least twice the face value. If the interest rate isn’t enough to double the bond’s value, then the Treasury makes a one-time adjustment 20 years after the bond was issued to make up the difference. In effect, if you hold a Series EE bond for 20 years, you’d earn an annual yield of at least 3.5 percent.
Disadvantages
- Savings bonds can have relatively low yields. Series EE bonds issued from May to October 2022 earn a rate of just 0.1 percent, while Series I bonds issued during the same period pay a much higher 9.62 percent yield, which will fluctuate depending on the consumer price index.
- Savings bonds aren’t very flexible. They’re locked in for at least a year and incur a penalty of the last three months’ interest if redeemed in less than five years.
- Individuals are limited to how much they can invest in savings bonds — $10,000 a year in each series.
Bonds vs. savings accounts
Pros and cons of bonds
| Pros | Cons |
|---|---|
| Series I bonds can offer a higher yield than savings accounts. | Bonds can’t be cashed in for at least a year, and there’s a penalty for redeeming any bond before five years have passed. |
| Bonds are backed by the U.S. government. | Savers can earn more on a savings account than from a Series EE bond (unless they are able to take advantage of the bond’s special 20-year privilege). |
Pros and cons of savings accounts
| Pros | Cons |
|---|---|
| Savers can generally withdraw money from the account up to six times a month without penalty. | Savings account yields typically fall when interest rates fall. |
| Savings accounts are backed by the Federal Deposit Insurance Corp., which insures the account up to $250,000 per individual, per institution. | Some savings accounts may have minimum balance requirements that are higher than bonds. |
| Some savings accounts, especially high-yield accounts, may pay better interest than a savings bond. |
Bottom line
Savings bonds are among the safest investment types, as safe as any government-backed type of investment such as high-yield savings accounts. Some factors to consider before investing in a savings bond include the bonds’ one year minimum for holding the funds and the interest rate offered — rates on different series can vary markedly.