What is a savings bond and how does it work?

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In a Nutshell

When you buy a U.S. savings bond, you’re lending money to the federal government, which will later pay you back in full — plus a little interest on top. Bonds are generally considered low risk. And while they don’t pay much interest, they can also come with some tax advantages.
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Did you ever get a savings bond from an older relative as a birthday or holiday gift when you were a kid? Were you less than impressed? You might have been a lot more excited if you’d understood what that bond really meant: Uncle Sam owes you.

“Think of it like an IOU, and you’re the lender,” says Brent Weiss, a co-founder of Facet Wealth. “You lend money to the (federal) government for a specified period of time. At the end of the term, they pay you back in full, and there’s interest on top of the purchase price.”

U.S. savings bonds are designed as easy and safe investments to help people save money. You can buy one online, from $25 up to $10,000 in a calendar year, keep it for a few decades as agreed, and get back your principal plus a little interest once you cash it in.

Savings bonds are considered one of the safest ways to save money because they’re issued by the U.S. Treasury and backed by the federal government.

Savings bonds come with some tax advantages and little risk, but they also don’t give you much money in return compared to other types of investments. Whether you got one as a birthday gift from Grandma or you’re considering buying one, here are things to know about U.S. savings bonds and how they work.

What is a savings bond?

When you buy a U.S. savings bond, you’re basically lending money to the federal government. The U.S. Treasury issues bonds, while the federal government guarantees them to ensure you get that money back.

When the bond no longer earns interest, it’s matured and it may be time to cash it in — or reinvest the money. If you redeem the savings bond once it matures, you’ll get the money you lent plus all the interest that accrued. But if you redeem the bond before it matures, you’ll lose out on some of the potential interest you would have earned if you waited the full period — and you may even pay a penalty, depending on how early you cash it in.

You can buy up to $10,000 of each type of bond in any calendar year. The federal government currently issues two types of savings bonds, while local governments offer their own type.

I bonds

Introduced in 1998, I bonds come with a combined fixed and inflation-adjusted interest rate, which accrues for up to 30 years. When you redeem the bond, you’ll get back the face value plus the accumulated interest. You’ll know the fixed rate when you purchase the bond. But because the inflation rate is based on the consumer price index for all urban consumers (CPI-U), the bond’s inflation-adjusted rate can change every six months.

The combined interest rate (of both the fixed and CPI-U-driven rate) is currently 1.90% for I bonds issued from May 2019 through October 2019.

You can check out this rate chart to see the rates on your bond, depending on when it was issued.

Series EE bonds

Series EE bonds were introduced in 1980 and are guaranteed to double in principal if you hold them for at least 20 years. If you purchased these bonds between May 1997 and April 2005, they’ll earn a variable interest rate, while bonds issued after May 2005 will earn a fixed interest rate until they mature. The current Series EE interest rate is 0.10% for bonds issued from May 2019 through October 2019.

Municipal bonds

Municipal bonds, or muni bonds, are issued by state and local governments and may be used to fund day-to-day obligations or even pay for a particular project, like a new school. These bonds make interest payments at regular intervals and have a set maturity date. They could be a good fit if you’re looking for a tax shelter, as the interest they earn is generally not subject to federal income tax. And, if you live in the state where the bond was issued, you may not pay local or state taxes either.

Learn about tax-exempt interest

What are the pros and cons of U.S. savings bonds?

Like any type of investment, savings bonds can have advantages and disadvantages. For example, savings bonds can be a good fit if you want a low-risk way to save money and you can take advantage of a few tax breaks.

But, “with low risk comes low returns,” Weiss says.

Pros of investing in U.S. savings bonds

  • You’re guaranteed to get back the entire principal amount plus interest if you keep the bonds until maturity, meaning they carry a much lower risk than other investment options.
  • Bond holders won’t pay state or local taxes on the interest, and they can defer paying federal income tax on the interest the bond earns until they cash it in.
  • Eligible taxpayers may qualify for a tax break when they use Series EE and Series I savings bonds funds to pay for qualified education expenses.
  • Unlike other types of securities, there are no markups or fees for buying bonds. They’re sold at face value. For example, if you want to buy a $50 bond, you’ll only pay $50 for it.
  • Kids can hold U.S. savings bonds in their own names (hence their popularity as birthday and graduation gifts). Minors can’t hold most other securities in their own names.
  • Buying a bond helps support the U.S. government — an aspect of bonds that has appealed to many Americans’ sense of patriotism over the years since bonds were first introduced in 1935.

Cons of investing in U.S. savings bonds

  • Savings bonds are low risk, but that means you won’t earn as much as you would with a more aggressive investment.
  • If you want the maximum return on your investment, you have to hold onto U.S. savings bonds for a long time — most keep paying interest for 30 years. You can cash them in sooner, as long as you’ve held the bond for at least a year. And if you cash them in before holding them for five years, you’ll also lose the last three months of interest.
  • When you cash in the bond, you’ll have to pay federal income taxes on the interest earned unless you use the funds to pay for higher education.
Learn about compound interest and how it works

How to use a savings bond

If you inherited or found an old savings bond, you can check its value using the Treasury’s Savings Bond Calculator. You’ll need to know the type of bond, its serial number and the date it was issued. If you keep the bond until it matures, you can collect all the accumulated interest when you redeem it.

Buying a savings bond

In the past, savings bonds were paper documents with serial numbers that you could buy at a bank or through the mail. Now, you can buy an electronic savings bond online at TreasuryDirect.gov. They’re available in penny increments, from $25 up to $10,000 each year.

You can only buy electronic Series EE bonds. But if you use your federal income tax refund to make the purchase, you can still buy paper Series I bonds.

Cashing in a savings bond

If you have an old paper savings bond, you can redeem it at most financial institutions. Electronic savings bonds can be cashed in at TreasuryDirect.gov and directly deposited into your checking or savings account. Once you redeem the bond, the financial institution or TreasuryDirect should send you — possibly not until after the end of the year — a Form 1099-INT, which reflects your taxable gain. If you cash a paper bond at a financial institution, it may even give you the form right away.

Because savings bond interest is subject to federal income tax, you can either report it and pay tax every year that you hold the bond or wait until the end and pay the tax all at once.

Bottom line

Savings bonds have been around for a long time, and they’ve been a first-time investment for generations of Americans who received savings bonds as gifts when they were kids.

U.S. savings bonds typically offer a low rate of return, but it’s a guaranteed return. If keeping investments low risk is important to you — and you have time to allow the investment to fully mature — savings bonds may be a good choice for your overall investment and savings portfolio.

If you’re not sure how savings bonds could fit in with your overall financial plan, you may want to speak with a financial adviser to work on your financial goals and create a plan for achieving them.

About the author: Kim Porter is a writer and editor who has written for AARP the Magazine, Credit Karma, Reviewed.com, U.S. News & World Report, and more. Her favorite topics include maximizing credit card rewards and budgeting. Wh… Read more.