Money Matters

Comparing fixed-rate savings bonds to CDs

April 27, 2013 

Q. I just tried to buy an I bond at my bank and they said I can only buy them online now. Is that true? If so, how does it work and how safe is buying a bond online? The person also suggested I buy a one-year CD since I bonds aren’t paying much. She said the fixed rate is zero. How high does the inflation rate need to be to justify buying a bond with a fixed rate of zero versus a CD?

A. It’s true that as of Jan. 1, 2012, paper savings bonds are no longer issued through financial institutions. The U.S. Department of the Treasury estimates that this will save the American taxpayers close to $70 million in just the first five years. The only way to purchase savings bonds (other than with your tax refund – see IRS publication number 4830) will now be in electronic form. The site for Treasury Direct is http://www.treasurydirect.gov. It is a very secure site and after you establish an account, there are several layers of security codes needed to sign into your account. The website is also very informative about bonds, bills and notes issued by the Treasury Department.

As you seem to know, the earnings rate is a combination of two separate rates: a fixed rate of return and a variable semiannual inflation rate. The fixed rate is announced by the Treasury Department every May and November. This rate remains the same for the life of the bond. The semiannual inflation rate also is announced each May and November by the Treasury Department. This rate is based on the Consumer Price Index reported by the Bureau of Labor Statistics. The semiannual inflation rate is combined with the fixed rate to determine the I bond’s earnings rate for the next six months.

The semiannual inflation rate announced last November was 0.88 percent. So, even with the fixed rate at zero, I bonds issued on or after Nov. 1, 2012, currently have an annualized 1.76 percent rate of return. New rates will be announced May 1. If the combined fixed and semiannual inflation rate is 1.25 percent or higher, this is probably just as good as a one-year CD. These bonds are meant to be long-term investments but they are fairly liquid. You can cash the bond anytime after you have owned it for 12 months. You receive your original investment plus earnings, but there is a three-month earnings penalty if you cash the bond within five years of date of purchase.

If the composite rate is 1.25 percent and you cash out in 12 months, you’ll receive the same amount of interest as you would on a 12-month CD paying 1 percent. As an added plus, the earnings are exempt from state and local income taxes.

Federal income tax on interest earnings are deferred for up to 30 years, until redemption or other taxable disposition, whichever comes first. The I bond is sold at face value in denominations of $25 or more up to $10,000. If you have college tuition needs, you may be able to exclude all or part of the interest on I bonds from income as long as the proceeds are used to pay for tuition and fees at eligible post secondary educational institutions (see IRS publication 550 for details).

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624

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