Savings Bonds: Earnings Guaranteed?

Istock

When it comes to savings bonds, those too-good-to-be-true guarantees aren't phony.

With interest rates so low these days, how would you feel if I said you could earn 3.5 percent annually, backed by the U.S. government? Well, to be precise, it's 3.53 percent. And if I mentioned that there would be no state or local taxes, and that you could defer paying federal taxes for two decades, would that sound good? Maybe too good?

Get money and investment savings tips in the AARP Money Newsletter

This too-good-to-be-true rate comes courtesy of the U.S. Treasury's old-fashioned EE savings bonds. There is a little-known feature that, if held for 20 years, your bonds must at least double in value, which translates to a 3.53 percent annual return. Why haven't you heard about it? Because no one has the incentive to tell you.

This isn't a new feature. Mel Lindauer, a moderator of the nonprofit Bogleheads (an online discussion forum emphasizing low-cost, diversified and disciplined investing), wrote about it years ago as a way to build your own annuity. I'll go into that in a bit. But first, the rules, risks and reasons to consider old-fashioned EE savings bonds.

The rules

A person can buy up to $10,000 a year in series EE bonds, which can be purchased at TreasuryDirect.gov. Banks no longer sell them. The minimum purchase is $25. If you don't hold them for the full 20 years, you get only the current rate, which is 0.1 percent annual return.You can't redeem them the first year, and you pay a penalty of three months' interest if you want your money back in the first five years — though at 0.1 percent interest, that doesn't amount to much.

The risks

There are two primary risks. The first is that if you need your money back in less than 20 years, you earn that measly 0.1 percent annual rate. The second is that, if we have high inflation, the money that doubled could actually buy less. Remember, however, that no one knows future inflation. Inflation has recently lagged the 2 percent target set by the Federal Reserve. Still, you wouldn't want to put all of your savings into this strategy.

Reasons to use EE bonds

EE bonds can have great relevance to your planning. As mentioned, Lindauer suggested building your own annuity. For example, if you wanted to build a future cash stream to supplement Social Security, you could buy $5,000 in savings bonds annually starting at age 50 and, beginning at age 70, be assured of an "annuity" of $10,000 a year for the next 20 years, which is nice longevity insurance.

Additionally, EE bonds are good for some education costs, since funds used for higher education may be federally tax-exempt as well. But there are some restrictions: allowable for tuition but not for books or room and board, for example. More rules apply here, in that the bonds must be in the name of a parent who earns less than $92,000 a year if single and $145,000 if married. Both amounts are likely to be increased in the future. So, if you are about to become a grandparent, gifting savings bonds to your child could work out great. Timing is critical, as the college costs must be paid in the same year the bond is redeemed.

Finally, any long-term horizon for the money can make sense, whether for you or a loved one. The stock market is likely to surge and plunge at least once during the next 20 years, and having some of your nest egg in this double-your-money strategy, backed by the U.S. Treasury, can provide peace of mind.

My advice

Though there is no such thing as a free lunch, Lindauer states in a recent Wall Street Journal article that there is "at least dessert." Treat yourself to this tasty, free dessert for part of your savings and investments.

Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.