When the United States issues treasury bonds, bills, and notes, they are asking you, the taxpayer, for a loan. In exchange for that loan, they pay you a set interest rate just as you pay credit card and mortgage companies a set interest rate to use their money.
Many of us as children received savings bonds as gifts. These were easy to purchase and used to offer an attractive rate of return but is that still true today? There are two types of savings bonds left: the I bond and the EE bond. We’ll leave the I bond for another time but let’s take a look at the EE bond.
How Does an EE Bond Work?
You can purchase an EE bond in any amount down to the penny but as of January 1st, 2012, you can only purchase them through the Treasury Direct website. You’re allowed to purchase a maximum of $10,000 worth of EE bonds annually.
EE bonds pay a fixed interest rate over the 30 year life of the bond. After 20 years the Treasury guarantees that the bond will double in value regardless of the fixed rate. The Treasury recalculates the interest rate for new issue bonds each May 1 and November 1. You can find the current rates by clicking here .
EE savings bonds are ultra-safe investments because they are backed by the full faith and credit of the United States. Unless the United States goes bankrupt, you cannot lose your principal investment. Finally, savings bonds are highly liquid.
You can redeem your bond after twelve months but if you redeem it prior to the first five months, you lose the last three months of interest payments. If you redeem your bond after five years there is no penalty.
Series EE savings bonds come with attractive tax advantages. First, they’re exempt from state and local taxes. Federal taxes are differed until redemption allowing the interest earned to grow tax free throughout the life of the bond.
Additionally, if you’re using your bond to pay qualified education expenses, you may end up with no Federal tax liability. Review IRS Form 8815  and Publication 970  to determine your eligibility for an exclusion of Federal taxes.
What’s the Catch?
Savings bonds are perfect for the individual investor who is looking for a safe, easy to understand investment product but along with that safety comes another problem: You might have a tough time earning enough interest to outpace inflation. Despite the fact that the Treasury guarantees the bond will double after 20 years, the annualized rate of return may still not outpace inflation.
Other investments, like municipal bonds or some investment grade corporate bonds or bond funds may offer a high degree of safety but pay higher rates of return and in the case of municipal bonds, have similar tax treatment. For education saving, state sponsored 529 plans or Coverdell plans come with the same tax advantages but may offer a higher return.
Although the safety of owning an EE bond might be desirable, in low interest rate environments, savings bonds are probably not the best way to put your money to work. High interest rate environments, like we saw in the early 1980s, made savings bonds a powerful and safe source of revenue.
Because the Treasury has changed the way savings bonds are issued and redeemed numerous times over the past 20 years and as early as the beginning of 2012, don’t trust any information you read outside of the Treasury direct website. Click here  to read about savings bonds on their site.