In the current investment climate it's extremely difficult to find a security that offers safety, liquidity, or a decent yield, let alone some combination of these attributes. But if you're willing to look outside of the usual fixed-income options, you can get all of the aforementioned for your clients, along with some extra benefits for higher education expenses. Savings bonds can earn more money with less risk for your clients, and earn you some of your clients' well-deserved gratitude.
Newly-issued U.S. savings bonds have 30-year maturities and come in two versions: Series EE, and Series I. The EE bonds currently pay a fixed rate of just 1.1 percent. (More later on how that can get better.) The Series I bonds have two components to calculating the current yield. The first is a fixed portion that remains static for the life of the bond, and is currently at “zero” for new buyers.
The second part is an inflation-adjusted layer that is subject to a potential change every May and November. Right now the effective annualized yield is 4.6 percent, a rate Series I bond owners will enjoy at least until November of 2011. That relatively attractive figure is even better than it appears, since the interest is subject only to federal income taxation and won't get hit by state or local taxes.
There are few investments available that have less payment or market risk than savings bonds. The bonds are technically Treasury securities, and therefore backed by the U.S. government.
Unlike typical Treasury bonds, though, savings bonds aren't sold in the open market, and therefore owners who may need to liquidate the securities before maturity won't be subjected to future price fluctuations and uncertainty.
Instead, savings bonds owners can redeem the bonds as soon as 12 months after purchase, incurring a minor penalty of just three months of interest. After five years of ownership, there is no penalty whatsoever for cashing in the bonds.
Savings bond owners can choose to declare (and pay taxes on) the interest earned via one of two methods: either annually as the interest is credited, or when the bonds mature (or are redeemed).
So clients who are in a higher tax bracket now (i.e., “working”) can buy savings bonds now without worrying about the interest adding to their current taxable income.
If and when the clients are in a lower tax bracket (i.e., “retirement”) they can cash in the bonds. At that time they will not only be more likely to pay less in taxes, but also be more likely to need the money.
Some of your clients might even be able to completely avoid taxation on savings bond interest, as long as a few conditions are met.
First, the bonds have to be owned by an individual who was at least 24 years old at the time of purchase.
The savings bonds also have to be redeemed in a calendar year in which the family incurs qualified higher education expenses, at a qualifying institution.
To qualify for the exemption, the student has to be attending a school that participates in the federal financial aid program. The expenses can include tuition, and other fees and supplies — but not books, or room and board.
Furthermore, the parents' adjustable gross income (AGI) has to be below certain amounts at the time of redemption. The AGI limits are determined each year, but for 2011 the exemption is phased out from $106,650 to $136,650 for married couples filing jointly, and $71,000 to $86,100 for all other types of filers.
Another way parents of all ages and income can use savings bonds to reduce the family's tax bill is to purchase the bonds in their children's names, and then declare the interest each year, instead of upon redemption.
In theory, the interest on bonds owned in the children's name will be taxable. But the income of most minors is likely to be low enough that the actual tax bill will be little or nothing.
Keep in mind, though, that bonds owned by the children may reduce need-based college financial aid awarded in the future, and upon reaching the age of adulthood, the kids are free to do what they wish with the bonds — for better or worse.
Even though the yield of Series I bonds can theoretically go to zero (but no lower) in the future, most investors would still rather opt for the I bonds instead of the currently lower-yielding EE bonds.
But the EE bond yields may get a nice bump for those who are willing to wait long enough. The government guarantees that EE bonds bought today will at least double in value, if held for at least twenty years.
That means that if a buyer of a Series EE bond for $500 today can hold it for two decades, he'll receive $1,000, and his annual effective yield over that time will work out to about 3.5 percent.
Yes, it's still a little less than what a Treasury bond with a similar maturity currently pays, but the Treasury bond also has a much higher level of market risk if the client needs the money (and needs to sell the bond) before the maturity date.
You and your clients can get more information on savings bonds of all types by visiting www.treasurydirect.gov, and learn about some of the quirky details involved in the purchasing process.
The bonds can be bought either online at the site, or in person at most banks and credit unions. The minimum purchase amount is $50 for bonds bought in person, and $25 for those obtained online.
The maximum that can be purchased is $5,000 per person per year online, and the same amount in person.
Clients may be disappointed to find out that they can only put a total $10,000 into each kind of bond, each year. But you can help them implement and maintain a systematic program of annual purchases that could amass a more significant amount over time.
Hopefully, you'll eventually have a more attractive alternative to offer.
Kevin McKinley CFP is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.mckinleymoney.com.