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Evaluating Series EE bonds. (Federal Taxation).

Series EE savings bonds bought on or after May 1, 1997, earn interest based on five-year Treasury security yields. The rate for EE bonds is 90% of the average yields on five-year Treasury securities for the preceding six months. They are zero-coupon bonds because interest is not paid until maturity.

Unlike the typical zero-coupon bond, where the taxpayer must report an amount of accrued interest annually, the investor can choose to defer reporting interest earned on an EE bond until it is cashed, stops earning interest at final maturity, or is disposed of in some other way (such as an ownership change through a reissue transaction).

Because deferring income is almost always preferable to paying current taxes, one must assume that all EE bondholders would postpone reporting accrued interest. This may make EE bonds more attractive than other U.S. Treasury instruments. Clearly, then, there is a tradeoff: To defer the reporting of income, one must take a 10% haircut on the earnings of the index on which the interest is based.

For the sake of simplicity, assume a constant 40% marginal tax rate and interest payments at a constant rate of 10%. It would take eight years before the value of tax deferral exceeded the value of foregoing the interest-rate haircut. On the other hand, if the interest rate were a constant 4%, which is more in line with today's interest-rate environment, it would take at least 18 years for the deferral to be more valuable than foregoing the haircut. Obviously, if tax rates are lower than 40%--that is, if the investor is in a lower tax bracket--it would take even longer to reach the break-even point. If such a bond is cashed in before it is five years old, the last three months' worth of interest are lost.

Is it worth purchasing Series EE bonds? At present, they mature after 17 years, although they can be extended for an additional 13. If interest rates do not average more than 6% during that period, the EE bonds will not be the better choice, assuming that the investor can obtain a similar investment without the haircut or deferral. In short, in low interest rate environments the value of deferral is relatively small, and the cost to achive the benefit, the haircut, may be larger.

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Author:Metzger, Leon
Publication:The CPA Journal
Article Type:Brief Article
Geographic Code:1USA
Date:Mar 1, 2002
Words:385
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