Government Savings Bonds

Series EE bonds

Series EE bonds were first issued in 1980. The face amount printed on the bond is known as its denomination, which ranges from $50 to $10,000. Electronic EE bonds are issued at face value starting at $25. Instead of paying interest to bondholders, EE bonds are a form of zero-coupon bond. This means that the value increases in set increments and continues to gain in value for as long as you own it or until it matures.

In the past, EE bonds have been available in either paper or electronic form. Paper EE bonds were sold at a discount equal to one-half of the face value of the bond. In other words, a bond with a face value of $100 would cost you $50.

For EE bonds purchased before May 1, 2005, the maturity date (i.e., when the bond reaches its full face value) depends on the interest rate of the bond at the time you purchased it. For purchases on or after May 1, 2005, EE bonds earn fixed rates of interest and are guaranteed to mature in 20 years. If a EE bond does not double in value as a result of applying a fixed rate for 20 years, the Treasury will make a one-time adjustment in value at original maturity to make up the difference. Rates for new issues are adjusted each May 1 and November 1, with each new rate effective for all bonds issued through the next six months.

Interest accrues monthly and is compounded semiannually. You can hold EE bonds for 30 years or cash them in (redeem them) before that time. The original principal plus accumulated interest is payable upon redemption.

Series I bonds

Series I bonds, an extension of the Treasury’s inflation-indexed bonds, became available in September of 1998. They are intended to encourage Americans to save more by offering protection for interest income against future swings in the cost of living. They are available in several denominations from $50 to $10,000.

Series I bonds are sold at face value, and all interest is paid at redemption along with the face value. These bonds increase in value every month, receive compounded interest on a semiannual basis. The interest is subject to federal income tax but not to state or local income tax. However, Series I bonds allow you to defer federal taxes on the interest for up to 30 years. Series I bonds issued on or after February 1, 2003 have a 12-month minimum holding period.

Series HH bonds

The Series HH Savings Bond is a current income security once issued in paper form by the Treasury Department. Series HH bonds could not be bought with cash, and, as of September 1, 2004, investors are no longer able to reinvest HH/H bonds or exchange EE/E bonds for HH bonds. People who own Series HH bonds can hold onto them until maturity,

Series HH bonds were first offered in 1980. These bonds pay interest every six months, but they do not rise in value like Series EE bonds. The original maturity date on Series HH bonds is 10 years, after which they can continue to earn interest for another 10 years, for a final maturity of 20 years after the bonds were originally issued. However, the rates change after the first 10 years. Like other government savings bonds, the interest on Series HH bonds is subject to federal income tax, but not to state or local income tax.

Top quality

Government bonds are backed by the full faith and credit of the U.S. government, which collects taxes to pay bond owners. Because of this, there is almost no risk of losing your investment.

Relatively easy to buy and redeem

You can purchase savings bonds directly from the U.S. Treasury, though you would need to set up a free TreasuryDirect account at www.treasurydirect.gov to do so. You also can use that account to convert paper savings bond to electronic form. Those holding paper savings bonds can still redeem government savings bonds at most banks. Some employers will also let you invest in savings bonds through automatic payroll deductions.

Interest is exempt from state and local taxes

The interest you receive from these bonds is exempt from state and local income taxes. However, the interest income is usually subject to federal income tax. This may not be the case, however, for Series EE bonds that are used to pay for college tuition (see below).

Interest may be exempt from federal income tax

Taxpayers who meet certain income limits and usage requirements may be able to claim a federal income tax exemption for the interest they receive on Series EE bonds used for education savings. To claim the exemption, the proceeds of the bonds must be used to pay for educational expenses.

You can defer taxes on the interest

Series EE bondholders generally report interest they receive when they redeem the bond or when the bond reaches maturity. However, the IRS will let you report the interest in the year that it is actually earned if you make an election to do so. For more information, consult IRS Publication 17.

May be difficult to figure out the interest rate and the rate of return on your investment

Series EE bonds issued prior to May 1, 2005 do not come with an explicitly stated interest rate. The interest rate on these bonds is pegged to the average yield of other government securities for the previous six-month period, determined each May 1 and November 1.

In addition, bonds issued prior to 1995 follow a two-tiered rate schedule. One rate schedule follows a government-guaranteed rate of return; the other follows market-based interest rates. The total interest you receive on your bonds is calculated under each schedule. You receive the higher total.

May not protect your investment from inflation

With the exception of Series I bonds, the rate of return on most U.S. savings bonds is pegged to fixed interest rates. If the rate of inflation rises, your investment will have less buying power.

On the other hand, Series I bonds are designed to protect you from inflation. You earn a fixed base rate plus a rate that is adjusted semiannually for inflation. The rates are declared twice a year, in May and November. The fixed rate portion remains the same for the life of the bond.

Cannot be sold or used as collateral for a loan

Unlike other U.S. government securities including other types of government bonds, government savings bonds cannot be sold in a secondary market. Moreover, you cannot pledge them as security to obtain a loan.

Taxes are generally due in the year the bond is redeemed

If you use the cash method of accounting (as most individual taxpayers do), you generally report the interest on U.S. savings bonds when you receive it. If you use an accrual method of accounting, you must report interest on U.S. savings bonds each year as it accrues. When you cash in a bond, the bank or other payer that redeems it must give you a Form 1099-INT if the interest part of the payment you receive is $10 or more.

If you have Series EE bonds or Series I bonds, you generally pay any income taxes in the year you redeem the bonds or at maturity, whichever comes first. The difference between the purchase price and the redemption value is taxable interest. However, if you elect to do so, the IRS may let you pay income tax on the interest from your bonds in the year the interest is earned. You must use the same method for all Series EE and Series I bonds that you own.

With Series HH bonds, interest is paid twice a year by direct deposit into your bank account. If you are a cash method taxpayer and have Series HH bonds, you must report interest on these bonds as income in the year you receive it.

Income taxes are due when bonds change hands

When the ownership of a savings bond changes, it creates a taxable event (or disposition). If you give government savings bonds to a minor child, for example, you are liable for income taxes on all interest earned up to the date of the transfer. Tax liability for any interest that accrues thereafter passes to the child, who is likely to be in a lower tax bracket than you.

A gift of government savings bonds is a taxable disposition

Taxable events occur when the owner of savings bonds has them reissued in the name of a co-owner or a beneficiary, or gives the bonds to another person and reissues the bonds in that person’s name. A taxable event also occurs when the owner of the bonds makes an irrevocable transfer to a trust.

Before the transfer, the current owner must pay income taxes on any accrued interest, and he or she may be liable for any gift taxes on the transfer. The transfer value would be the entire value of the bond at the date of the transfer.

The bonds are not revalued upon the death of the owner

Unlike other investments, government savings bonds are not marked up to fair market value when you die. Estate executors have three options when reporting income from these investments. They can elect to:

• Report any unreported interest on the final income tax return
• Report all the savings bond interest in the estate, or
• Distribute the bonds to the beneficiary

In the third case, the beneficiaries can report the savings bond interest when the investment is redeemed, or they can make an election in any year to report previously unreported interest.

A number of other rules apply to bonds, such as how to report taxes when bonds are sold between interest dates. For more information, see IRS Publication 17 and/or consult a financial planning professional.