I am convinced that the Series I savings bond program remains one of the most underrated investments for the average American in history. So much so that I wrote tens of thousands of words on the topic over at my the Investing for Beginners site. But tonight, I was writing a new piece of content to add to the savings bond hub that will be published before morning when it just hit me how truly underrated these are as an alternative to savings for low income and middle class families.
Let me give you an example: Right now, the average national rate on a 1-year certificate of deposit at a bank is 0.93%. You must pay Federal and state taxes on that. If you are in the 25% bracket in a tax-free state, your net return is going to be around 0.70%. On the other hand, you can buy a Series I savings bond that can’t be cashed in for at least one year, collect 4.6% interest that is tax-free on both a Federal and State level if you use them for education expenses, and is guaranteed by the Federal government to not lose money. On a tax-adjusted basis, this is the same as a 6.13% yield on a fully taxable certificate of deposit.
What if you don’t use the money for education expenses? You can still defer the taxes owed on Series I savings bonds indefinitely by electing something called “cash basis reporting”. That way, your Federal taxes are deferred until the earlier of the year of final maturity, redemption, or other taxable disposition. That is a huge advantage, effectively providing much of the same deferred taxation benefits of a Traditional IRA. Over time, the cumulative advantage of that tax treatment can be enormous.
Which would you rather have for tying up your money? A certificate of deposit paying a taxable equivalent of 0.70% or a Series I savings bond paying a taxable equivalent of 6.13%? Those are your economic choices at this exact moment.
Series I Savings Bonds Have Their Limits
[mainbodyad]Don’t misunderstand me. I don’t think Series I savings bonds are good investments all the time, or that they should be a part of every investor’s bond portfolio. Actually, they aren’t really investments at all but really savings mechanisms. But for the average person who has a decent job, a good house, a 401(k), a Roth IRA, and just wants to put aside money for the future (at least 12 months or more) and help ensure the money keeps pace with inflation so it is there whenever it is needed (e.g., paying for college, putting a down payment on a house, tapping into for emergencies, etc.), I just don’t think Series I savings bonds can be beat.
One of the things I find most compelling about the Series I savings bond is that it effectively gives you the benefit of up to 30 years compounding without any bond duration. That means if rates increase drastically, you still won’t see a capital loss, whereas with an ordinary 30-year municipal bond or corporate bond, you could see a 50% or more paper loss that would take years to regain.
An Overview of How Series I Savings Bonds Work
- Right now, the Series I savings bond offers an interest rate of 4.60%. This is calculated because these bonds pay an interest rate based upon two components:
- The “earnings” rate: This is set to 0.00% for the life of the bond since rates are so low
- The “inflation adjustment” rate: This increases or decreases with fluctuations in the consumer price index for all Urban Consumers (CPI-U). Right now, this is 4.60% but it will change as the price index fluctuates.
- You can sell your bonds any time you want after 12 months without any loss. Your penalty is limited to 3-months of interest income and it is only owed if you cash in your savings bonds within the first 5 years
- You don’t have to pay Federal or state income taxes on your interest income in some cases if you use them for qualified educational expenses
- You can elect for cash basis reporting of the interest income on your savings bonds, effectively deferring your tax bill for up to 30 years so you have more money compounding for you
- Interest compounds semi-annually for 30 years
- Series I savings bonds are bought at face value
- Can be held in paper form or electronically through Treasury Direct
- You can invest up to $5,000 per Social Security Number per year
Take someone in the 25% personal tax bracket. The current yield on the Series I savings bond of 4.6% is the equivalent of getting 6.13% on a taxable 1-year certificate of deposit! The national average right now is only 0.92%, or 0.69% net of taxes. That means you are getting 888.4% more interest income on your savings bonds than you are with a certificate of deposit! Why would any rational person buy a certificate of deposit when the opportunity cost is so high? It doesn’t make any sense.
The biggest challenge for high income earners is the $5,000 limit per Social Security number, but that can be somewhat managed. If you are a family of five, two adults and three young children, you could save $5,000 per person, per year, or $25,000 in total each year. Over a few years, you’d be able to reach into the six-figures.