How Do Savings Bonds Work?
You've likely heard of savings bonds, but what exactly are they and how do they work? Join us as we answer these questions and more. We'll give you the scoop on different types of savings bonds, where to get them, and whether or not they are the right investment choice for you.
What Is a Savings Bond?
You know how when you file your taxes, you usually end up owing the government money? If you've ever wished it could be the other way around, then savings bonds are a way to make that dream a reality.
A savings bond is more or less a loan that you can make directly to the government. Each year that the bond stays active, the money you initially paid for the bond gains interest and continues to grow. Unlike traditional bonds, which pay out interest regularly, you won't receive the interest on a savings bond until you actually redeem it.
Also unlike traditional bonds, which expire at a certain date, a savings bond can mature and stay active for up to 30 years after the initial purchase.
How Do Savings Bonds Work?
Savings bonds are one of those investments that tend to be pretty straightforward. You can simply select the type of bond or bonds you'd like to buy (more on that in a moment), how many you'd like to purchase, and then buy them directly from the government at treasurydirect.gov.
The nice thing about bonds is that they are sold at their current face value. In other words, if you want to buy a $25 bond, then it will cost you $25. Once you own the bond, there's not much left to do except wait for it to mature.
Before making your purchase, be sure to think about the length of the bond you'd like to buy and check out any late fees you may incur if you decide to cash it out before its maturity date.
Bonds Vs Savings Account
Bonds and savings accounts are both easy ways to set aside money, but which one is right for you? It largely depends on exactly how long you want to set the money aside. Savings accounts are a great place to stash money while earning an interest rate from your bank.
Because you can still withdraw the money from a savings account at any time, however, they tend to have pretty shabby annual percentage yields or APYs. According to Bankrate, the average savings account in 2021 will earn you around 0.06% of the money you have invested each year.
But keep in mind that's the average. Some banks pay an APY as low as 0.01%, while you might get up to 0.55% on the higher end. Regardless, you're looking at a return on your investment of well under 1% per year.
Savings bonds are meant to be a way to invest for the long haul. While their returns still aren't astronomical, they tend to offer better rates than savings accounts because they're meant as more of a long-term investment you don't intend to cash out on for years or even decades.
Different Types of Savings Bonds
- Series EE Bonds
If you have an old EE bond from before May 2005, then it may be earning a variable interest rate. That said, bonds issued after May 2005 now earn a fixed interest rate, currently of 0.10%. While that doesn't initially sound too stunning, the upside of the Series EE bond is that the government now guarantees to double your investment if you wait at least 20 years to cash it out.
- Series I Bonds
Series I bonds work a little differently, in that they offer both a fixed fate (currently 3.54%) and an inflation rate. The inflation rate is calculated twice a year and is based on the Consumer Price Index for urban customers. Series I bonds are a nice way to protect your investment from becoming a meager payout due to the long-term effects of inflation.
Where to Get Savings Bonds?
Currently, the easiest way to buy a savings bond is directly from the government treasurydirect.gov. While you used to be able to buy paper savings bonds at financial institutions, the government cut that option in 2012 to encourage more people to buy them electronically.
Currently, Series EE bonds are only available in electronic form, while Series I bonds are available in both electronic and paper form. Should you prefer to purchase a Series I bond in paper form, you can do so whenever you file your tax returns.
You can also buy bonds as gifts for another person. Bonds are a great idea for babies, as they'll usually have incurred a respectable amount of interest by the time the kid is old enough to have any interest in cashing them in.
Are Savings Bonds a Good Investment?
A better way to put it would be to say that savings bonds are about as safe as it gets when it comes to investing. They're 100% backed by the U.S. government, so unless the unthinkable happens and the government goes bankrupt, your money is safe and secure.
Additionally, they're only subject to income tax on the federal level, so when you cash them in you won't be taxed on your earnings at the state or local levels. The only exception would be if the state you live in happens to have any inheritance or estate taxes that they may be subject to.
In some instances, such as using them to pay for higher education, you may even be able to avoid paying taxes on them entirely. Last but not least, there's a lot to be said for the fact that Series I bonds include protection against inflation, which is always a concern when it comes to long-term investing. Due to these considerations, savings bonds tend to be a solid choice when it comes to saving for retirement.
Advantages and Disadvantages of Savings Bonds
As with any other type of investment, savings bonds come with both advantages and disadvantages. Here's a quick overview of their advantages and disadvantages:
- They are among the safest investments that you can make
- They're available for low minimum investments
- There are no fees or expenses for owning them. The only exception may be if you chose to cash them out early, in which case you may lose some of your interest.
- While you may not want to exclusively invest in savings bonds, they are a great way to leverage risk in your overall portfolio
- Because of their low risk, their earning potential is lower than higher-risk investments such as stocks.
- They have less liquidity than some other investment types. As opposed to a savings account or even stocks or ETFs, you should only invest money in a savings bond if you're willing to forget about it for quite some time. While you can technically redeem a savings bond after 12 months, you'll lose three months' worth of interest if you redeem them within the first five years