Net Gains: Is Grandma's Savings Bond a Dud?

May 14, 2008 — -- Whether by design or by accident, the trusty U.S. savings bond may be in its waning days.

Recent moves by the federal government encourage small investors to forego savings bonds and, instead, to purchase other types of U.S. Treasury securities.

The latest blow to what has been a gift of choice for generations of grandparents, aunts and uncles came May 1, when the U.S. Treasury announced new savings bonds rates. For purchases between May 1 and Oct. 31, the fixed rate on new Series EE bonds will earn a miserly 1.40 percent, while new Series I bonds will carry a 4.84-percent rate.

That 4.84 percent rate on Series I bonds sounds decent, but you might want to hold off until you hear the details behind that number.

Series I bonds, which are meant to keep pace with inflation, earn interest at a rate that is a combination of two parts. One part is an inflation-based rate that adjusts twice a year; the second one is a fixed rate that remains the same over the course of an I bond's 30-year life.

It was the fixed-rate portion of the new I bond rate that stunned savings bond fans. It is 0 percent, down from 1.2 percent in the previous six months.

That means any I bond you buy between now and October will earn nothing above and beyond the inflation rate. If inflation falls to zero, or if we enter a period of deflation, you would receive no interest payments on I bonds purchased during the current six-month spell.

The inflation-adjusted piece currently pays 4.84 percent based on recent numbers that capture a rise in consumer prices. The inflation adjustment could rise or fall when it is reset next on Nov. 1.

This is the first time in the I bond's history the fixed rate has paid nothing. The previous low had been 1.00 percent on I bonds purchased between May 1, 2004, and April 30, 2005.

One thing to keep in mind is that the fixed rates on I bonds bought before May 1 are unaffected by the new 0 percent rate. Depending on when they were bought, the fixed-rate portion could pay as high as 3.60 percent.

An I bond bought in 2000 could pay in total as much as 8.44 percent, given the 3.60 fixed rate and the current inflation-adjusted rate of 4.84 percent.

Observers of the savings bonds program believe the 0 percent fixed rate for I bonds is just the latest sign the U.S. Treasury Department seeks to phase out savings bonds and encourage small investors to, instead, buy Treasury bills, notes and bonds.

"Combined with the EE bond rate and the reduction in maximum purchase limits, it's like the Treasury is heaping scorn and ridicule on Savings Bond investors," says the Savings Bond Advisor Web site, run by Tom Adams, author of a book by the same name.

Late last year, the U.S. Treasury Department announced a reduction in the limit on annual savings bond purchases from $30,000 to $5,000. That limit applies to each type of savings bond -- paper, electronic, Series EE and Series I -- so, it is possible to accumulate as much as $20,000 in a given year, but that is still down from the previous $120,000 potential.

The move, the Treasury Department said, "was made to refocus the savings bond program on its original purpose of making these non-marketable Treasury securities available to individuals with relatively small sums to invest."

It noted that 98 percent of all annual savings bond purchases fall within the $5,000 limit.

Then, in March, the Treasury Department made U.S. Treasury bills, notes, bonds and Treasury Inflation-Protected Securities (TIPS) more appealing to small investors by lowering the minimum purchase amount. Investors now may buy these federal government securities in multiples of $100, down from $1,000.

The lower minimum applies both to marketable Treasuries bought online at www.treasurydirect.gov and in the secondary market from private dealers.

The logical conclusion is the federal government wants small investors to buy more Treasury bills, notes and bonds, but fewer savings bonds. The cost and complexity of selling savings bonds exceeds other Treasuries because many savings bond investors prefer the old paper bonds to buying and holding them electronically.

Taken together, the miserly interest rates offered on savings bonds, smaller savings bond purchases and easier access to other Treasury securities, are likely to diminish the attractiveness of savings bonds.

Savings bonds, however, offer one major advantage you can't get from other Treasury securities -- tax-free interest is available on savings bonds if they are used to pay for college expenses by an adult meeting income limits set by the IRS.

Also, the tax on savings bond interest is deferred, meaning you do not have to pay it until you cash in your savings bond.

Even with these benefits, it's tough to recommend the trusty savings bond.

The question is, what will grandparents, aunts and uncles do without it?

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com