EE vs. I bonds: which are better? U.S. savings bonds can be an integral part of an investment strategy.

EXECUTIVE SUMMARY

* CPAs WHO PROVIDE FINANCIAL PLANNING SERVICES need to weigh the similarities and differences between U.S. Treasury series EE bonds and I bonds to help clients make savings bonds a part of their investment strategy.

* SERIES EE AND SERIES I BONDS HAVE interest rates that vary over the life of the bonds. No interest is paid on either EE or I bonds until they are redeemed.

* PAPER SERIES EE BONDS ARE SOLD AT 50% of face value, with an individual maximum purchase of $60,000 face value per year. Electronic EE bonds are sold at face value with an annual purchase limit of $30,000. Series I bonds are sold at face value; individuals can purchase a maximum of $60,000 face value per year ($30,000 paper bonds and $30,000 electronic bonds).

* FOR FEDERAL INCOME TAX PURPOSES, both series EE and series I bondholders may recognize the interest income on an accrual or cash basis.

* BOTH SERIES EE AND SERIES I BONDS issued on or after February 1, 2003, have a 12-month minimum holding period. A penalty equal to the last three months of accumulated interest applies to bonds redeemed within five years of their issue date.

* EE BONDS ARE GUARANTEED TO REACH THEIR MATURITY at face value within 20 years, which means the minimum effective pretax annual rate of return is slightly more than 3.5% with semiannual compounding. There is no such guarantee for I bonds.

* IF SERIES EE OR SERIES I BONDS ARE CASHED IN to pay for qualifying higher-education costs, taxpayers can exclude the accumulated interest from their income.

During these days of stock market uncertainty, many investors are looking for safer, more conservative investments. Market returns often are subject to a great deal of volatility, and the return on most bonds is heavily influenced by changes in interest rates. Interest rates are currently low but have begun to rise. The rate of inflation also has been low. A return of inflation would force interest rates upward and decrease the market value of a bond investment, resulting in a loss of capital for those forced to sell prematurely. For investors who are concerned about a possible loss of capital or who are seeking safer and more secure returns, there are some other options available. CPAs who provide financial planning services should know about a relatively new investment alternative offered by the U.S. Treasury Department--series I savings bonds.

The Treasury Department began issuing "I" bonds on September 1, 1998. They are similar to the better-known series "EE" bonds in many ways, but they differ in several important aspects. This article compares and contrasts the characteristics of EE bonds with I bonds, then compares their respective performances from the date I bonds were initially issued through May 1, 2004, the latest announced interest date. Understanding the similarities of and differences between these two options, EE and I bonds, will enable CPAs to better help clients who want to make savings bonds a part of their overall investment strategy.

SERIES EE BONDS

The federal government began issuing paper EE bonds in July 1980. Paper EE bonds are issued at a discount of 50% of their face value. The government offers them in denominations (face value) of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. Generally, a client may spend up to $30,000 (that is, $60,000 face value) per calendar year on paper EE bonds. The federal government began issuing electronic EE bonds in May 2003. Electronic bonds are not issued at a discount, but rather are issued only at face value. Generally a client may spend up to $30,000 per calendar year on electronic bonds. The chart below summarizes the annual purchase limitations:

   Paper Bonds        Electronic Bonds      Total Annual Limit

Face Value   Cost    Face Value   Cost      Face Value    Cost
$60,000    $30,000    $30,000   $30,000      $90,000     $60,000

A rate of interest, calculated as 90% of the six-month average of five-year Treasury securities, is applied to the bonds semiannually, resulting in an interest rate that varies over the life of the bonds. Although accrued interest is added to the bond value monthly, actual compounding is done on a semiannual basis. The Treasury Department announces new rates each May 1 and November 1. Once the Treasury announces a new rate, it applies to all bonds issued or held during the next six-month holding period.

Example. An investor who wanted to purchase a $10,000 paper bond on June 1, 2004, would pay $5,000 or 50% of the face value. Since the May 2004 interest rate was 2.84% (annual rate), this bond would earn interest for the first six-month holding period (June 1, 2004 through November 30, 2004) at 2.84%. Even though the government would announce a new interest rate on November 1, 2004, the old 2.84% rate would remain in effect for this bond until the end of the first six-month holding period, which in this example is November 30. Then, beginning on December 1, the new rate which was announced the previous November 1 would apply.

A special feature of EE bonds issued alter May 31, 2003, is that they are guaranteed to reach their maturity at face value within 20 years. If the computed interest rates were so low over this 20-year time span that they precluded the bonds from reaching maturity value, the Treasury Department would make a special one-time adjustment to increase the value of the bonds to maturity value. Consequently, the minimum effective pretax annual rate of return for these bonds would be slightly more than 3.5% with semiannual compounding over a 20-year period. The EE bonds earn interest for a maximum of 30 years (known as the final maturity date), after which time interest no longer accrues.

Unlike many bonds that make cash interest payments to bondholders at specified times, EE bonds do not pay interest until they are redeemed. For bonds issued on or after February 1, 2003, there is a 12-month minimum holding period before the owner may cash in an EE bond; bonds issued before that date have a six-month minimum holding period. In addition, the government assesses a penalty equal to the last three months of accumulated interest on bonds redeemed within five years of their issue date.

EE bonds are exempt from state and local income taxes. For federal income tax purposes, an EE bondholder may recognize the interest income either on an accrual or cash basis. There may be tax advantages to either approach depending on the circumstances and tax status of the bond owner. A bondholder with limited income, such as a child, generally would want to report the interest as it accrues each year. As long as the taxpayer has low levels of income in future years, no tax would ever be paid on the interest income. CPAs would need to file a tax return on the taxpayer's behalf (even when a return is not technically required) to make the election to accrue the interest. Alternatively, if these taxpayers choose to report the income on a cash basis only when the bonds are redeemed--the bunching of the interest income into a single year could subject the interest to income tax.

Taxpayers in relatively high tax brackets generally prefer to delay reporting interest until the bonds are redeemed, especially if they anticipate being in lower tax brackets at the time of redemption, perhaps at retirement. CPAs can recommend such strategies to maximize the effective aftertax rate of return.

Taxpayers must use the same accounting method, cash or accrual, for all EE and I bonds they own, but they can change methods from one year to the next. A taxpayer may switch from the cash to the accrual method without asking the IRS for permission. In the year of the change, taxpayers must include in income all EE and I bond interest accrued to date and not previously reported. They also would have to use the accrual method on any new savings bonds subsequently purchased. A switch from the accrual to the cash method requires IRS approval; however, permission automatically is granted if the taxpayer follows service guidelines. These guidelines can be found in IRS Publication 550, Investment Income and Expense.

In the past EE bond owners could defer reporting their interest income beyond the normal maturity date by exchanging their EE bonds for HH bonds. Under this option the EE bond interest was not reported until the HH bonds were redeemed or matured. Since the government stopped issuing HH bonds on August 31, 2004, taxpayers no longer have this choice. However, they still can avoid paying federal taxes on the accumulated interest on EE bonds by cashing in the bonds to pay for qualifying higher education costs (tuition and fees) for themselves, their spouses or their dependents. The interest is excludable as long as the aggregate redemption proceeds (interest and principal) do not exceed the qualifying expenses. Qualifying educational expenses must be reduced by any amounts the taxpayer takes into account in computing the Hope and Lifetime Learning credits, scholarships, distributions from education IRAs and similar excluded sources of income. The exclusion also is subject to phase-out provisions. The EE bonds must have been issued after December 31, 1989, to individuals who were at least 24 years old at the date of issuance to qualify for the education exclusion.

A REVIEW OF SERIES I BONDS

The government issues series I bonds in the same denominations as series EE bonds--$50, $75, $100, $200, $500, $1,000, $5,000 and $10,000. Unlike EE bonds, however, I bonds are issued at face value. Clients may buy a maximum of $60,000 worth of I bonds each year: $30,000 in paper bonds and $30,000 in electronic bonds. As with EE bonds, the current rate of interest for each I bond is announced every May 1 and November 1.

The interest rate on I bonds is a combination fixed and variable rate. The Treasury determines the fixed rate each May 1 and November 1. Once the Treasury determines a fixed rate, the rate applies to all bonds issued during the six-month period. The initial fixed rate does not change for a particular bond over time; it applies throughout the bond's life (up to 30 years).

The government determines the variable interest rate component using the Consumer Price Index for All Urban Consumers (CPI-U), published by the Department of Labor's Bureau of Labor Statistics. This variable rate, also announced on May 1 and November 1, applies to each semiannual interest period. The May rate is based on the percentage change between the consumer price index figures from the preceding October through March six-month period. The November rate is similarly based on changes in the CPI-U from the preceding April through September period.

Example. An I bond purchased on June 1, 2004, would have an initial semiannual variable rate of 1.19% (the rate announced on May 3, 2004) that would apply from June 1, 2004, through November 30, 2004. The November 2004 rate would apply from December 1, 2004, through May 31, 2005. Thus, unlike fixed rates, which do not change over the life of a bond, the variable rate in effect when a bond is purchased applies only for the next six-month period.

The composite rate (fixed plus variable) is determined as follows: Composite rate = [fixed rate + (2 X variable rate) + (variable rate X fixed rate)]. Therefore, for the announced rates on May 1, 2004, the composite rate is: 0.010 + (2 x 0.0119) + (0.0119 x 0.01) = 3.39%.

But what would happen if the CPI-U should measure deflation? In this situation the combination of the negative inflation rate and the fixed rate theoretically could cause the composite rate to become negative, resulting in a loss of carrying value. However, the Treasury Department has built in some degree of protection for the investor. It will not allow the composite rate to fall below zero. Thus, the carrying value of an I bond investment cannot fall below the bond's most recent redemption value in a period of deflation. But unlike series EE bonds, which are guaranteed to reach face value within 20 years, there is no such guarantee with series I bonds. The only certainty is that the bonds will not Fall below the most recent redemption value during any six-month period.

Other than rate differences, the interest features of 1 bonds are virtually identical to those of EE bonds. No interest is actually paid to the holders of I bonds until they cash in or redeem the bonds. As with EE bonds, there is a 12-month minimum holding period for bonds issued on or after February 1, 2003, and a six-month minimum holding period on 1 bonds issued be fore February 1, 2003. The government also assesses a penalty equal to the last three months of accumulated interest on bonds that are redeemed within five years of their issue date.

I bonds are exempt from state and local income taxation. For federal income tax purposes, taxpayers again have the choice of reporting interest currently or deferring interest until they redeem the bonds or the bonds stop accruing interest (currently after 30 years). Unless deflation completely offsets the fixed-rate portion of the bond during some period, interest earned each period is determined by the increase in the bond's carrying value over the prior period. According to the Treasury Department, if an I bond is used to pay for qualifying higher educational expenses in the same manner as EE bonds, the related interest can be excluded from income.

INVESTMENT RESULTS: EE VS. I

Since the advent of series I bonds, interest rates and inflation rates generally have favored them over EE bonds. Exhibit 1, below, shows issue date interest rates for both series since May 1998.

The U.S. Treasury Department maintains a Web site with a "savings bond calculator" (www.publicdebt.treas. gov/sav/savcalc.htm) that allows CPAs to compare actual or hypothetical investments. Exhibits 2 and 3, at right, show the results of this calculator comparing a $1,000 investment in an I bond with the same investment in EE bonds (consisting of two $1,000 face value bonds) made in September of 1998 (exhibit 2) and September of 1999 (exhibit 3). The interest earned as of May 1, 2004, is shown for each bond investment. Exhibit 4, below, is a graphical representation of the relative performance of each bond investment shown in exhibit 2.

While I bonds generally have outperformed EE bonds, the return on I bonds could fall to zero if inflation rates decline or perhaps become negative. This downside risk, however, appears to be relatively small. In addition, as noted in exhibit 1, rates on EE builds sometimes are higher than that of 1 bonds. Still, long-term data suggest I bonds tend to be the better investment, especially when inflation is present.

ALTERNATIVE INVESTMENTS

I bonds offer investors an alternative to traditional EE savings bonds. Both are backed by the U.S. government and both offer significant tax advantages. Compared with traditional CDs and many other bonds, they are exempt from state income tax. Furthermore, clients who use savings bond interest to pay qualified educational expenses owe no federal tax. If, for example, an investor who is in a 25% federal and 8% state income tax rate bracket had $100 of fully taxable interest from a savings account, he or she would net only $69 aftertax. (The combined effective tax rate is 31%, since state income tax is deductible for federal income tax purposes.) On the other hand, if interest from an EE or 1 savings bond were used to pay qualified educational expenses, the $100 earned could potentially yield the full $100, a difference of $31. Thus, if current pretax yields were 5%, a taxable savings account would yield only 3.45% affertax while the savings bond could yield the full 5%.

CPAs can weigh the ins and outs of EE bonds and I bonds to advise their clients on which type to consider. Although the bonds are similar, there are some significant differences. Both EE and I bonds have features that can make them an attractive investment alternative for some clients, especially those looking for adequate and safe re turns or those who can use the bonds to pay for higher-education expenses.

Exhibit 1: I/EE Bond Issue Date Interest Rates
Since the Introduction of I Bonds

                            Series I bonds

                              Semiannual   Annualized   Series EE
Announcement       Annual      variable    composite      bonds
date             fixed rate      rate         rate         rate

September 1998      3.4%        0.62%        4.66%        5.06%
November 1998       3.3%        0.86%        5.05%        4.60%
May 1999            3.3%        0.86%        5.05%        4.31%
November 1999       3.4%        1.76%        6.98%        5.19%
May 2000            3.6%        1.91%        7.49%        5.73%
November 2000       3.4%        1.52%        6.49%        5.54%
May 2001            3.0%        1.44%        5.92%        4.50%
November 2001       2.0%        1.19%        4.40%        4.07%
May 2002            2.0%        0.28%        2.57%        3.96%
November 2002       1.6%        1.23%        4.08%        3.25%
May 2003            1.1%        1.77%        4.66%        2.61%
November 2003       1.1%        0.54%        2.19%        2.61%
May 2004            1.0%        1.19%        3.39%        2.84%

Exhibit 2: Investment Made September 1998

             Initial                  Bond
Type of     purchase    Interest    values at
bond          price      earned     May 2004

Series EE   $1,000.00    $278.40    $1,278.40
Series I    $1,000.00    $385.60    $1,385.60

Exhibit 3: Investment Made September 1999

             Initial    Interest      Bond
Type of     purchase    Interest    values at
bond          price      earned     May 2004

Series EE   $1,000.00    $212.00    $1,212.00
Series I    $1,000.00    $297.20    $1,297.20

Bond Purchases

The total dollar value of outstanding paper EE and I bonds issued in calendar year 2003 and in the first four months of 2004 was about $13.8 billion. The total dollar value of outstanding EE and I bonds issued electronically through the TreasuryDirect system over roughly the same period was slightly more than $1 billion.

Source: U.S. Department of the Treasury.

PRACTICAL TIPS TO REMEMBER

* CPAs can weigh the ins and outs of EE and I bonds in order to advise their clients on which type of bond to consider. Although the bonds are similar, there are some significant differences. Both have features that can make them an attractive investment alternative.

* Bondholders with limited income generally should report EE/I bond interest as it accrues each year. As long as the taxpayer has low levels of income in future years, no tax ever would be paid on the interest income. CPAs would need to file a tax return on the taxpayer's behalf to make such an election to accrue the interest.

* CPAs can recommend taxpayers in relatively high tax brackets delay reporting interest until the EE or I bonds are redeemed, especially if they anticipate that the taxpayer will be in a lower tax bracket at the time of redemption, perhaps at retirement.

* CPAs can visit a Treasury Department Web site, www.public debt.treas.gov/sav/savcalc.htm, to use a savings bond calculator to compare actual or hypothetical investments.

RESOURCES

* Department of the Treasury, Bureau of the Public Debt. www.publicdebt.treas.gov.

* Form 8818 and Instructions, for individuals redeeming bonds for qualified education expenses.

* IRS Publication 550. Investment Income and Expenses.

* IRS Publication 970, Tax Benefits for Education.

* IRS Teletax phone line. 800-829-4477 (topic 403).

RICHARD F. BOES is professor of accounting at Idaho State University, Pocatello. His e-mail address is [e-mail]. MARK BEZIK is assistant professor of accounting at Idaho State. His e-mail address is [e-mail].