U.S. savings bonds—often given as graduation, baptism, birthday, and wedding gifts—are popular because they are, for all practical purposes, 100 percent risk free, and they can be easily purchased at most banks, at government financial institutions, at work, or through the U.S. Treasury either by mail or online. However, until the introduction of the I type savings bond, bonds—typically EE savings bonds—offered little growth potential.

What are I bonds?

I bonds are U.S. government savings bonds issued at face value. This means that to purchase a $100 type I bond, it would cost $100. In contrast, traditional EE savings bonds are discounted bonds. They are usually issued at one-half the face value. This means that to purchase a $100 type EE bond, it would cost $50.

Unlike EE bonds, I bonds pay two types of interest—a fixed rate, plus an inflation interest adjustment every six months, based on the federal government’s Consumer Price Index (CPI-U). The interest on EE bonds is 90 percent of the six-month averages of five-year Treasury Bills. Also, unlike EE bonds, if the country’s economy runs into a period of deflation, the value of I bonds does not decrease. I bonds continue to earn interest until they are redeemed or reach final maturity, 30 years from the date of issuance. However, they can’t be redeemed for the first six months after purchase, and any redemption during the first five years will result in a three-month interest penalty.

Tax considerations

Like EE bonds, I bonds offer tax incentives to the investor.

(1) Interest is exempt from state and local income tax.

(2) Federal tax on interest (both fixed interest and the semiannual adjustment) can be deferred until bonds are redeemed or reach final maturity.

(3) Interest used to pay for college education costs could be partially or fully excludable (for details concerning this exclusion contact your local Internal Revenue Service representative or inquire online at www.irs.gov). Please note that deductible interest can only be used to pay for higher education costs. It cannot be used to pay for private preschool, kindergarten, elementary, or high school education.

Investment advantages

Although I bonds can’t produce the type of growth and income that we have seen over the most recent years in America’s stock market, there are some advantages to investing in I bonds.

* They are safe. Like most security instruments issued by the U.S. government via the U.S. Treasury, I bonds are backed by the full faith of the U.S. government.

* They are easy to purchase. I bonds can be purchased through most larger workplaces, banks, credit unions, government banking institutions (Federal Reserve Banks or Congressional banks), or online at www.savingsbonds.gov. Online I bond purchases are limited to $500 in a single transaction and $30,000 per year. However, they can be made 24 hours a day, seven days a week. If you purchase I bonds online, you will need to purchase by credit card, so make sure you can pay off the entire purchase price charged on the credit card within the next billing period. If you can’t, don’t purchase online.

* They don’t require monitoring. Unlike most other investment tools, I bonds can be bought regularly and then forgotten. You do not have to monitor their daily activities to decide whether it is best to sell or not to sell. They continue to build in value until final maturity. There is no annual reporting required and no annual tax implications.

* They are excellent investment tools for children under 14. Children in this group with income otherwise subject to the kiddie tax can benefit by investing in I bonds. Since interest on the bonds does not need to be reported annually, they are usually not subject to additional kiddie tax.
They can be used for education. Parents may want to invest in I bonds so that they can be redeemed to pay for college expenses. If parents’ income is below a threshold amount in the year the bonds are redeemed, the interest could be fully excludable. If I bonds are in the parents’ names they don’t count against a student qualifying for student aid.

* They are logical alternatives to CDs. People who routinely buy bank CDs and regularly roll them over may want to consider I bonds. I bonds are safer than CDs, they usually pay a higher interest rate, and they are exempt from state and local tax. However, they are not as liquid as CDs.

Conclusion

Type EE U.S. savings bonds are the type of bond that most average Americans think about when considering investing in savings bonds. However, if you are interested in safe, worry free, long-term investing with deferred tax implications you might want to investigate type I U.S. savings bonds. Although they have more restrictions than EE regarding immediate redemption, if you are able to keep them to maturity, the benefits far outweigh the restrictions.

Originally posted 1/19/2012.