Savings Bonds and Savings Accounts

    

The typical savings account, which consists of demand deposits, offers the convenience of immediate withdrawal; however, where on-demand withdrawal of funds is not paramount, U.S. savings bonds, generally, and the Series I Bond, specifically, offer a better hedge against the crippling effects of taxes and inflation on investment returns than do standard bank products, including the certificate of deposit (CD).

Bank deposits in the United States are insured up to $250,000 by the federal deposit insurance corporation (FDIC)¹. The FDIC, in turn, is backed by the U.S. Treasury Department. And it’s also the U.S. Treasury that guarantees interest payments on U.S. savings bonds. Therefore, both bank deposit interest and savings bond interest are considered "risk-free investments", as they both derive the benefit of the U.S. Government’s guarantee.²

For those unable or currently unwilling to enter the world of investing in stocks, bonds, mutual funds, and real estate (among other investments that carry varying degrees of risk), the question of how savings bonds and savings account differ may be worth further investigation. Below, we’ll look at two types of savings bonds, the series EE and the series I, as well as two types of bank savings deposits, the demand and the time deposits.

Bear in mind that the single overriding goal of every investor is to maintain or increase future purchasing power for goods and services. Other than risk considerations (buying dot.com stock at the height of a stock bubble), the scourge of income taxes and inflation is the greatest hindrance to maintaining and increasing purchasing power.

Savings Accounts

Although most every adult in America is familiar with the basic concepts of a savings account, it is worthwhile to make the distinction between demand and time deposits because, as you’ll see below, the rules of ownership that are involved in making decisions about U.S. savings bonds have comparative elements of both demand and time deposits that are found in banks.

Demand Deposits: deposit money into the account and withdraw funds (on demand) any time.³

Time Deposits: These deposits are represented by certificates of deposit (CD); and are characterized by time constraints. For example, a person may open a 1-year CD and will be prohibited from withdrawing money prior to the expiration of 12 months… without being hit with a substantial penalty. Likewise, a person may gain a higher annual percentage yield (APY) by putting money on deposit for four or five years at a time.⁴

Savings Bonds

The U.S. Government offers two types of savings bonds for the individual, the series EE and the series I Bond. Here are features common to both bond series:

• Choice of deferring income taxes indefinitely (until bond is redeemed)
  
  • unlike a savings account, interest earned is not taxed each year; the bondholder may put off paying any income taxes for decades… while growing wealthy.
 
• Exempt from income taxation at the state and local level
  • by contrast, savings account interest is taxable at all levels; that is federal, state, and local income taxes.
 
• If the Bond is redeemed for Qualified Higher Education Expenses, the Interest earned may be free from all taxation
  • Nothing comparable exists with a bank savings account

Additional Benefit Exclusive to the series I Bond:

• Series I Bonds specifically offset the effects of inflation
  • Savings accounts and EE Bonds are at the mercy of inflation

Rules of Ownership for both bond series:

• Savings bonds must be held at least 12 months before they can be cashed at all (similar to having a 1-year CD at a bank)
 
• If a person cashes (redeems) a savings bond prior to holding it for 60 months, then a slight penalty is assessed (three months worth of interest is deducted).
 
• By using the U.S. Treasury’s electronic ownership account, an individual can purchase up to $5,000 of EE-bonds and also $5,000 of I-bonds.⁵

EE Bonds

The EE bond pays a fixed annual compounding rate of interest, depending on when the bond was purchased. That is, if an individual purchased a EE bond during the period of May through October 2007, then that bond will earn the published rate until maturity (it will then earn fluctuating interest for another 10 years). Once the EE bond is purchased, its particular interest bearing rate is fixed for up to 20 years.⁶ As for the most recent rates, for those EE bonds purchased between May and November 2008, they will earn 1.4% interest for 20 years. The anemic rate on the EE bonds stands in stark contrast to the very healthy rate of the series I-Bond. The difference in the two bonds is fully explained by the recent uptick in the inflation rate.

I Bonds

The I Bond’s interest rate is split into two pieces: one is a very small (sometimes zero) fixed rate and the other is a fluctuating rate specifically determined by the previous six months’ change in the inflation rate, as measured by changes to the consumer price index-urban (CPI-u). (See annual column in the government’s inflation table.)

When inflation is comparatively low (1.5 or 2 percent increase annually) the I Bond is nothing special. However, even during moderate inflationary periods, such as when inflation is running at annualized rates of around 4 percent (see 2008), the I Bond begins to demonstrate its worth. For the period of May through November 2008, the I Bonds’ fixed rate is currently set at 0.0; however, the second component of the calculation, the CPI-u, is causing the I Bond to currently produce a yield 4.84% annually. The bottom line is this: when inflation is running at historically low averages (less than 2 percent), the EE Bond will probably look more attractive; however, when inflation is running at even moderately high levels, the I Bond demonstrates its value in fighting the effects of inflation (as against savings products). If inflation ever ignites again like it has at moments in U.S. history (most recently it was above 11 percent annually in the early 1980s), then the U.S. Treasury’s I Bond begins to look better than gold.⁷ Additionally, for anyone looking to save for a child’s future college expenses, a large stack of I Bonds may offer quite a bit of help.

 

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Notes:

1. Follow the FDIC hyperlink to view an excellent, easy to follow video describing deposit insurance rules.

2. Whatever an individual may think of the U.S. Government, it is treated by global financial markets as singularly the least likely institution to default on interest payments that exists. Thus, the interest rate that the U.S. Treasury pays is considered by global investors as "the risk-free rate".

3. Some minor transactions limits apply on a monthly basis; however, those limits are simply designed to keep people from treating savings accounts as if they were checking accounts.

4. APY differs from annual percentage rate (APR) in that an APY calculation assumes that the depositor leaves interest earned within the account, so that additional interest is earned on the interest that has accumulated. This results in compounding interest. $10,000 deposited at 5% APY results in $10,500 being in the account on the last day of Year 1; however, since Year 2 earns 5% on $10,500, instead of merely on $10,000, then at the end of Year 2, the depositor will have $11,025 in the account. The additional $25 accounts for the difference between an APY yield and an APR yield. APR simply states the interest rate that is earned, but does not contemplate what happens to the interest after it is earned.

5. Additionally, if a person also wants to own savings bonds in paper form, an additional $5,000 of each series (EE and I), or $10,000 additionally may be held in paper form. This results in $20,000 worth of savings bonds ($10,000 electronic and $10,000 in paper form) that may be purchased by individuals each year.

6. It is up to 20 years because the bond is considered mature when it has doubled in value above the purchase price. If the published rate is only 3 percent, then the bond is guaranteed by the Treasury to mature in 20 years (even though its natural course would take 24 years). However, if the interest rate is 4 percent, it will naturally mature (double in value) at approximately 18 years.

7. Unlike gold, there are no insurance or storage costs for savings bonds. These ancillary costs of gold serve to kill the inflation-hedging benefit of the mineral over a multi-decade period. Also, any profit made on gold is fully taxable at both the federal and state levels. If you still have doubts, see "the Canadian Warren Buffett", Stephen Jarislowsky’s, Rule Number 2 towards the bottom of this article.