Savings Bonds - Tax Incentives to Boost Income
There is a large variety of savings bonds for added income and predictable returns. They offer better interest rates compared to savings accounts and are a good source of income in the long term. Bonds come in different types, for example, zero coupon, government, corporate, municipal, and others.
Buy Savings Bonds as a Tax Sheltering Financial Instrument
This is a safe investment instrument because returns are guaranteed by the government. There are high yield, agency, treasury, and other types. Other varieties are also offered, including mortgage-backed securities, inflation-indexed treasuries, treasury notes, and treasury bills. Savings bonds offer tax advantages in that holders pay no local or state taxes on interest earnings. What is more, federal taxes can be deferred for a certain period, i.e. until maturity. Some types of savings bonds offer additional benefits in the form of education tax exclusion. Qualified expenses include expenses that go toward hobbies, games, and sports, but only if paid while attending courses as part of a certificate program or degree. Lab fees and tuition fees also qualify as well as expenses for one’s dependents and spouse or partner. Savings bonds can be used to partially cover educational expenses or as an additional source of income.
Inflation-indexed and Appreciation-type Bonds
There are two main types – inflation-indexed and appreciation. The latter are government-backed and come with a variable rate that changes twice a year. They are exempt from local and state income tax but federal tax applies. There is a maximum and minimum purchase amount. In general, this is a long-term instrument that offers additional income for a period of up to 30 years. The annual rate of appreciation-type bonds is 0.5 percent. There are also inflation-indexed instruments which come with a rate that is adjusted for inflation. This product goes with a fixed interest rate and a maximum purchase amount of $10,000.
Interest Rates and Earnings
The interest rate varies. Some Series E bonds, for example, no longer pay interest while some Series EE come with an interest rate of 1.30 percent. The earnings also vary, depending on the year during which new bonds have been introduced. The interest rate also depends on the month of issue. For example, the interest rate of Series EE issued in December 2012 is 0.6 percent for denominations of $50 and the rate for bonds issued in October 2012 is 0.22 percent. Finally, the rate also depends on the denomination. The interest rate of Series HH is fixed. There are useful tools to calculate the value of different savings bonds, including online calculators. Users are asked to enter the issue date, serial number, and value as of today’s date. They also enter details such as the series (E, I, EE or savings notes) and the denomination ($10,000, $200, $50, $25, $10, etc.). Earnings tables and estimation calculators are also used.
Alternatives and Types of Risk
There are alternatives such as corporate and high yield bonds, but some risks should be considered, including market, liquidity, interest rate, inflation, and call risk. With credit risk, the issuer may fall behind on payments, but some instruments are considered safe. Treasuries are one example. Junk bonds have a high credit risk. Interest rates also play a role. Prices go down when interest rates go up and vice versa. Thus, rate fluctuations can be a major factor for bonds with longer terms because there is more volatility over a longer period. Interest rate risk is also closely linked with inflation risk. Whatever the type of instrument, there are several benefits, and one is preservation of the principal or the initial investment. Regular income is also a major benefit. Many consumers like the fact that bonds offer a steady source of income. The product of choice depends on long-term goals, risk tolerance, investing timeline, and other factors. In many cases, investors add savings bonds to a portfolio made of risky instruments to balance it and add a degree of stability.
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