How Do Savings Bonds Work?

How do savings bonds work

Investing comes with risk, but some investments are less risky than others. If you’re looking for a safe way to invest, then it might be worth finding out how savings bonds work. In fact, they are just one of a number of conservative investing options. Savings bonds are backed by the U.S. government and give a bit of a safety net to investors.

Keep in mind that often the higher the reward, the riskier the investment. So while savings bonds might not have the biggest return, they are less risky than other investments, like individual stocks. Let’s dig into what savings bonds are and when it might make sense to add them to your portfolio.

What are savings bonds?

Savings bonds are instruments of debt issued by the U.S. government to fund federal programs. In return, investors get both the principal and a small interest fee back at a later date. They can be issued for a face value of as low as $50.

Think of it like making a loan, but instead of lending money to a company, you’re lending money to the U.S. government. And because savings bonds are backed by the full faith and credit of the American government, they are considered one of the safest investments on the market.

Savings bonds were first introduced during the Great Depression by Franklin Roosevelt and were also issued during World War II. They became known as War Bonds as all the money raised went towards paying for the war.

How do savings bonds work?

Savings bonds are similar to other types of bonds. When you buy a savings bond, you buy it at face value and wait for it to mature. When the time is up, the U.S. government pays back both the face value and any interest that accrued. Depending on the type of savings bond, you may get double the face value. You can usually cash the bond in before it matures as long as you hold onto it for at least 12 months. But the longer you hold onto the bond, the more it is worth.

Types of savings bonds

There are two types of savings bonds, EE Savings Bonds and I Savings Bonds. Each has its own advantages and disadvantages, as well as different terms and rates.

EE Savings Bonds

EE savings bonds can only be purchased electronically. They are the most common type of bond. Any savings bond purchased after May 2005 earns a fixed rate. You will know exactly what the rate is when you purchase the bond. If you hold onto the bond for at least 20 years, you will get double the face value. You can only buy up to $10,000 of EE savings bonds in one year.

Pros

  • Guaranteed to double your return if held for 20 years
  • Easy to purchase
  • No state or local income tax

Cons

  • Low-interest rates
  • High-inflation could eat into returns
  • Have to hold onto them for a long time to get a high return

I Savings Bonds

With I savings bonds, you are not guaranteed to double the bond value after 20 years. Instead, in addition to the fixed interest rate, there is also an inflation rate that is calculated twice a year. This is to help make sure the value of your investment is not eaten up by inflation. You can also buy paper I savings bonds with your IRS tax return, for up to $5,000 a year, as well as up $10,000 worth of I savings bonds electronically.

Pros

  • Inflation rate means bonds earn money during periods of  high inflation
  • Easy to purchase
  • No state or local income tax

Cons

  • No guarantee to double your return
  • Interest rate varies
  • Can only invest $10,000 to $15,000 a year

How to invest in savings bonds

Savings bonds can only be bought directly through the U.S. Treasury, through your bank, or through the IRS. You can’t go to your stock broker, as they are not sold on the secondary market. If you want to buy a savings bond electronically, you can do so on the TreasuryDirect website, which is operated by the government.

You’ll need to open an account and provide your identifying information, including a Social Security Number, bank account, and email address. Once registered, you can purchase and redeem savings bonds and other types of government-issued bonds.

The monthly interest on savings bonds compounds twice a year, but does not gain interest after 30 years. That doesn’t mean you have to hold onto the bond for 30 years. You can sell any savings bonds you’ve purchased after 12 months. However, if you sell them before 5 years, you will forfeit the last three months of interest.

Another benefit of savings bonds is that they are tax-deferred. Federal income tax is only applied in the year the bond matures, is redeemed, or after 30 years. Savings bonds are exempt from state and local income taxes.

Should you invest in savings bonds?

If you’re looking for a way to diversify your portfolio with a safe investment, savings bonds could be the way to go. They are easy to purchase and relatively straightforward. Plus, they are backed by the U.S. government, which makes them one of the safest investments out there.

While just investing in savings bonds won’t build up your retirement nest, it’s always a good idea to have a variety of different investments to help hedge against risk. Savings bonds and other similar types of investments can do just that.

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