What Are Series EE and Series I Bonds?
These bonds are issued by the United States Treasury Department and allow for tax-free growth if proceeds are used to pay for a dependent’s education. These bonds do not pay out an income stream; instead, you can redeem them and the redemption value of the bond increases each month. Series EE Bonds have a fixed interest rate (see below) and Series I bonds have a variable interest rate.
Series EE Bonds
For Series EE bonds issued before May 1, 2005, they earn interest at a variable rate tied to five-year Treasury securities. For bonds issued on or after May 1, 2005, they earn a fixed interest rate. The rate is set on May 1 and November 1 for bonds issued in the following six months. Interest accrues monthly and is compounded twice a year.
Series I Bonds
The interest rate for Series I Bonds is calculated in two parts.
The first part of the interest rate is fixed and determined when the bond is issued. It is set on May 1 and November 1 for all bonds issued in the following six months.
The second part is based on a measure of inflation over the prior six months, and can be negative in deflationary periods. The composite interest rate will based on an annualized combination of these rates but will never be less than 0%.
I Bonds provide some buying power protection because their interest rate is linked to an inflation rate.
Who Are the Owners?
Anyone with a social security number may own a Savings Bond. There is no relationship between the beneficiary on a Savings Bond and the education tax exemption. The account owner is the person whose name is listed on the bond, even if someone else’s social security number is also on the bond.
The account owner controls the timing of the redemption of the bond and the use of the proceeds. If the account owner is a minor, then the minor’s parent has this control, but the minor may need to agree to the bond’s redemption.
How to Get Education Tax Benefits?
Funds may be used for any purpose. When used for education (tuition, required fees, the purchase of a Coverdell ESA, Prepaid Tuition Plan, or 529 Savings Plan), the bondholder may not have to pay tax on accrued interest or principal adjustments. Bonds must be held for at least five years to receive maximum benefits and penalty free redemption.
In order to get the education tax benefits the bond owner must meet two criteria:
1) The bond owner must be an adult taxpayer.
2) The bond owner must use the bond to pay for his or her own education, a spouse’s education, or the education of someone claimed on his or her income tax return.
What Are the Tax Treatments?
Contributions: Not deductible.
- Federal: Tax-deferred. The bond owner does not have to pay tax on earnings until the bond is redeemed. However, the bond owner may elect to pay federal income tax on an annual basis (see comments below).
- State and Local: There is no taxation of federal bonds by state or local tax authorities.
Withdrawals: Tax-free for federal taxes when used for qualified expenses, when the following conditions are met:
- The age of the bond purchaser when the bond was purchased was 24 or older.
- For Series EE Bonds, the bond was issued after 1989. All Series I Bonds are qualified.
- The bond proceeds (principal and interest) are used to pay for tuition and required fees at a qualified educational institution (see discussion of eligible educational institutions in the 529 Savings Plan section of this document), or to purchase shares of a 529 Savings Plan, a Prepaid Tuition Plan, or a Coverdell ESA. Note: room, board, books, travel, and personal expenses are not qualified expenses.
- The bond owner’s modified Adjusted Gross Income in the year of the bond’s redemption is less than certain inflation-adjusted amounts
- The bond owner must take an exemption on their income tax return for the student in the year the bond is cashed in.
- The bond owner must be the tax payer. The bond can be co-owned by the taxpayer’s spouse. Bonds co-owned by a parent and a child are not eligible for the education tax benefit. If the child is listed as the beneficiary (not the owner) the tax benefit may still apply.
What Are the Impacts on Financial Aid?
Financial aid formulas treat the bond value (principal plus accrued interest) as the owner’s asset. If a bond is co-owned by a parent and the student, then 50% of the bond will be treated as a parental asset, and 50% as a student asset.
What are the Contribution Limits?
Starting in 2012, taxpayers may purchase a total of $5,000 in EE bonds and $10,000 in I Bonds each year directly from the United States treasury and other means.
Can They be Transferred?
The bond owner may change the beneficiary of the bond at any time. There are limited opportunities to change the bond ownership. For details, please see www.savingsbonds.gov.
How to Buy These Savings Bonds?
Savings Bonds may be purchased directly from the United States Treasury at www.savingsbonds.gov, through payroll deduction, and by federal income tax refund.
The paper Savings Bond is being gradually phased out. Effective January 1, 2012, almost all new Savings Bonds will be electronic securities. Savings Bond purchases must establish an account with the United States Treasury at http://savingsbonds.gov/indiv/indiv.htm to purchase new bonds. Taxpayers may buy paper I Bonds after this date using their federal income tax refund.
What Are Other Important Notes?
Savings Bonds are backed by the “Full Faith and Credit” of the United States government, and are considered a very safe, very low-risk investment.
Savings Bonds cannot be redeemed within one year of purchase. Those redeemed between one year and five years of purchase are subject to an early withdrawal penalty equal to the prior three months interest.
Because Savings Bonds are considered a low-risk investment, the interest rates they pay may be moderate relative to other investments. Therefore, they may not be the best choice for a saver with a long-term savings horizon.
Since children have low income tax rates, and bonds owned by children are not eligible for the education income tax exemption, electing to claim the interest accrued on the Savings Bond on an annual basis may result in significant income tax savings over time. To take advantage of this tax saving strategy, you simply report all the accrued interest on all savings bonds owned by the child-taxpayer at the end of the year on their income tax return, and the interest that accrues in each subsequent year on subsequent income tax returns. Changing back is also possible (but challenging). See IRS Publication 550 or the instructions for IRS Form 3115.
Information about Savings Bonds can be found at www.savingsbonds.gov. This site also houses a Savings Bond value calculator that allows users to determine the accumulated interest, current interest rate, and other factors about a Savings Bond based on the Bond’s serial number and date of issue. It is this value, not the bond’s face value, which must be reported on financial aid applications.