Are Your Old Savings Bonds Still Earning Interest?

Do you, your parents, or elderly relatives have old E bonds, H or HH bonds, or the rare Savings Notes, lying around? If so, it may be time to cash in some of these bonds because they are no longer earning interest, and in some cases could have tax problems.

According to the U.S. Treasury Department, $12 billion in outstanding U.S. savings bonds no longer earn interest. Are your bonds among them? To answer that question, you need to know a little about how the various savings bonds came into being, how they work, their different maturities, and how they’re taxed.

The federal government first began issuing savings bonds, called E bonds, back in the mid-1930s. The bonds were issued in a range of denominations, and citizens bought them at a discount of 75 percent of face value. You paid $75 for a $100 bond, for example.

The government stopped issuing E bonds after June 1980 and replaced them with EE bonds, which calculate earned interest slightly differently than E bonds. Investors buy EE bonds at half their face value.

Investors receive interest from E/EE bonds only when they redeem the bonds. The bonds earn interest up to their “original maturity”—that is, when the accumulated interest and the original price paid for a particular bond total the face value of the bond. But interest payments are automatically extended after that, usually for periods of ten years, until the bond reaches its “final maturity.” At that point, the bond quits earning interest.

This is where matters get confusing for investors, because the final maturity dates vary. E bonds issued from May 1941 through November 1965 had 40 years to final maturity. As of this writing, nearly all of them have stopped earning interest.

E bonds issued from December 1965 through June 1980, however, have only 30 years to final maturity. As of this writing, all E bonds issued through April of 1975 have stopped earning interest.

The final maturity for all EE bonds is 30 years, and since none are older than July 1980, you have a few more years before they stop earning interest.

Do you still own any Savings Notes, also known as Freedom Shares, issued from May 1967 through October 1970 during the height of the Vietnam War? Like E/EE bonds, these bonds were issued at a discount with the interest deferred until redemption. Savings Notes had 30 years to final maturity and no longer earn interest.

H and HH bonds differ from other savings bonds in that investors buy them at face value and the bonds pay out interest in cash semiannually. The government first issued H bonds in June 1952. Those issued through January 1957 had final maturities of 29 years, 8 months. All H bonds issued after January 1957, until HH bonds replaced them in January 1980, have final maturities of 30 years. Again, as of this writing, H bonds issued up to April 1975 have stopped earning interest.

But HH bonds, which the government quit issuing after August 2004, have final maturities of only 20 years. Consequently, any HH bonds you have that are older than 20 years should be cashed in to get back the original investment (the face value).

Taxes on savings bonds are free of state and local taxes, but you pay federal taxes at your ordinary income tax rate. Because H/HH bondholders pay taxes on the interest as they receive it each year, they don’t owe any taxes when they redeem them—the final payment is simply a return of the original principal.

But with E/EE bonds and Savings Notes, you will owe taxes on the accumulated interest, assuming you elected to defer reporting the interest over the years, when you redeem them—or when they reach final maturity, even if you haven’t redeemed them. This interest income is taxable for the year of redemption or final maturity. If you missed that year—say you now realize some old E bonds you’ve got lying around the house matured years ago—you may need to file an amended tax return and possibly be subject to a late penalty and interest. Confer with your tax specialist.

For current information on whether any bonds you hold have reached final maturity, go to – http://www.treasurydirect.gov/indiv/tools/tools_savingsbondcalc.htm

Annuities

Although not unilaterally opposed to annuities, Demming Financial Services Corp. (DFSC) generally discourages their purchase. We never recommend pre-tax (qualified) annuities and rarely use after-tax (non-qualified) ones, and when we do, they are mostly due to 1035 exchanges. They are called this because 1035 refers to the specific provision in the tax code that allows for the direct transfer of one annuity to another, without creating a taxable event. These exchanges allow clients to consider replacing underperforming or high-cost annuities with lower cost alternatives, while preserving the tax-deferred status of qualified annuities already owned by clients.

We are not proponents of annuities because . . . .

1. High Cost: Costs are generally 2-4 times higher per year than other comparable investments. The average annuity has mortality expenses, in addition to normal management fees; mutual funds have only management fees.

2. Lack of Liquidity: Most clients need liquidity. Because of their surrender fees and 10% early withdrawal penalties prior to age 59½, annuities sacrifice that precious commodity called flexibility.

3. Loss of Tax Advantages: Although annuities are generally marketed on their tax benefits, just the opposite is the case. Annuities sacrifice the utilization of favorable long-term capital gains treatment and convert long-term gains to ordinary income at distribution. In addition, upon the owner’s death, an annuity condemns either the deceased or the beneficiaries to paying taxes on the accumulated cash build-up – the tragedy being that the beneficiaries sacrifice a ‘step-up in cost basis,’ thus exposing themselves to unnecessary taxes.

4. Misinterpreted Guarantee: Many times annuities are marketed as ‘risk-free’ investments that somehow absolve the personal responsibility of the individual. The investor is committing to a long-term investment horizon in order for that ‘guarantee’ to be fulfilled. The ‘cost’ for these assurances is prohibitive when overlaid against investment benchmarks over similar time horizons.

In summary, annuities are high-cost, illiquid investments that offer poor tax benefits at distribution. As long as capital gains rates are 5-15%, with the possibility of a step-up in cost basis at death being zero tax, annuities are not an attractive investment.

Fee-Based Billing

Over the last few years, Demming Financial Services Corp. has gradually been evolving into a predominantly fee-based organization, as most of you are already aware.

As a full-service financial planning firm, we are committed to serving the best interests of you, our clients, throughout all facets of life – from cradle to grave so to speak. In recent years, we have become more sensitive to the fact that after the accumulation phase of a person’s career ends, the distribution phase begins, where the focus is on retirement needs and preservation of capital. In recognition of this proactive yet labor-intensive approach, we have been emphasizing the entire life planning cycle, not just the accumulation portion.

Our revenue in the past has come from a combination of fixed retainer fees and assets under management. We feel that a transition to a more fee-based billing format will enable us to serve our clientele efficiently and effectively in the long term, while allowing us to be compensated whether or not investments are being made.

We believe trends are changing. We are getting older as a society and shifting from an accumulation period to a distribution period. This huge tidal wave of accumulated dollars will have to begin coming out from its tax-deferred status. All this translates into increased work and time for us and hopefully increased benefit to you.

As a financial planning firm that accepts its fiduciary responsibilities, we think that the trend toward a fee-based format is inevitable and appropriate.