Tax Tips
EE Bonds vs. I Bonds - March 2006
Richard Scrivanich - Partner
If you are looking for a conservative investment for your portfolio, you may be considering U.S. Treasury EE or series I savings bonds. Understanding their similarities and differences, as well as their tax consequences, will you decide whether to make savings bonds a part of your investment strategy.
Series EE Bonds
The federal government began issuing paper EE bonds in 1980. Paper EE bonds are issued at a discount of 50% of their face value. The government offers them in various denominations (face value). Generally, you may spend up to $30,000 (that is $60,000 face value) per calendar year on paper EE bonds. The federal government began issuing electronic EE bonds in May 2003. Electronic bonds are not issued at a discount, but rather are issued only at face value. Generally, you may spend up to $30,000 per calendar year on electronic bonds.
Interest is applied semiannually, calculated as 90% of the 6-month average of five-year Treasury securities, resulting in an interest rate that varies over the bond’s life. The Treasury Department announces new rates each May 1 and November 1. Once the Treasury announces a new rate, it applies to all bonds issued or held during the next 6-month holding period.
EE bonds issued after May 31, 2003, are guaranteed to reach their maturity at face value within 20 years. If the computed interest rates were so low over this 20-year time span that they precluded the bonds from reaching maturity value, the Treasury Department would make a special one-time adjustment to increase the value of the bonds to maturity value. EE bonds earn interest for a maximum of 30 years (known as the final maturity date), after which time interest no longer accrues.
Unlike many bonds that make cash interest payments to bondholders at specified times, EE bonds do not pay interest until redeemed. For bonds issued on or after February 1, 2003, there is a 12-month minimum holding period before the owner may cash in an EE bond; bonds issued before that date have a 6-month minimum holding period. In addition, the government assesses a penalty equal to that last three months of accumulated interest on bonds redeemed within five years of their issue date.
Tax consequences of EE bonds
EE bonds are exempt from state and local income taxes. For federal income tax purposes, an EE bondholder may recognize the interest income either on an accrual (as earned each year) or cash (when received) basis. There may be tax advantages to either approach, depending on the bond owner’s circumstances and tax status. You must use the same accounting method, cash or accrual, for all EE and I bonds you own, but you can change methods from one year to the next, if certain procedures are followed.
In the past, EE bond owners could defer reporting their interest income beyond the normal maturity date, by exchanging their EE bonds for HH bonds. Under this option, the EE bond interest was not reported until the HH bonds were redeemed or matured. Since the government stopped issuing HH bonds on August 31, 2004, taxpayers no longer have this choice. However, you still can avoid paying federal taxes on the accumulated interest on EE bonds by cashing them in to pay for qualifying higher education costs (tuition and fees) for yourself, your spouse, or your dependents. The interest is excludable as long as the aggregate redemption proceeds (interest and principal) do no exceed the qualifying expenses. Qualifying educational expenses must be reduced by any amounts taken into account in computing the Hope and Lifetime Learning credits, scholarships, distributions from education individual retirement accounts, and similar excluded sources of income. The exclusion is also subject to phase-out provisions. To qualify for the education exclusion, the EE bonds must have been issued after December 31, 1989, to individuals who were at least 24 years old at the date of issuance.
Series I bonds
The government issued series I bonds in the same denominations as series EE bonds—$50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. However, I bonds are issued at face value. You may buy a maximum of $60,000 worth of I bonds each year: $30,000 in paper bonds and $30,000 in electronic bonds.
The interest rate on I bonds is a combination fixed and variable rate. As with EE bonds, the Treasury Department determines the fixed portion of the rate each May 1 and November 1. The initial fixed rate does not change for a particular bond over time; it applies throughout the bond’s life (up to 30 years).
The government also determines the variable interest component each May 1 and November 1. This component applies to each semiannual interest period. The Treasury Department has built in some degree of protection from deflation for the investor, since the composite interest rate cannot fall below zero. Thus, the carrying value of an I bond investment cannot fall below the bond’s most recent redemption value in a period of deflation. But unlike series EE bonds, which are guaranteed to reach face value within 20 years, there is no such guarantee with series I bonds. The only certainty is that the bonds will not fall below the most recent redemption value during any 6-month period.
Other than rate differences, the interest features of I bonds are virtually identical to those of EE bonds. No interest is actually paid to the holders of I bonds until they cash in or redeem them. As with EE bonds, there is a 12-month minimum holding period for bonds issued on or after February 1, 2003 and a 6-month minimum holding period on I bonds issued before February 1, 2003. The government also assesses a penalty equal to the last three months of accumulated interest on bonds redeemed with in five years of their issue date.
Tax consequences of I bonds
I bonds are exempt from state and local income taxation. For federal income tax purposes, taxpayers can report interest currently or defer it until they redeem the bonds or the bonds stop accruing interest (currently, after 30 years). Unless deflation completely offsets the fixed-rate portion of the bond during some period, interest earned each period is determined by the increase in the bond’s carrying value over the prior period. According to the Treasury Department, if an I bond is used to pay for qualifying higher educational expenses in the same manner as EE bonds, the related interest can be excluded from income.
EE vs. I bonds
Both EE and I bonds are backed by the U.S. government; both offer tax advantages. Unlike traditional certificates of deposit (CDs) and many other bonds, they are exempt from state income tax and may offer other advantages when used to pay qualified educational expenses.
If you have any questions regarding EE bonds vs. I bonds investments or any other tax matter, please feel free to give me a call at (562) 698-9891.
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