Both I and EE bonds (all Treasury securities, in fact) are exempt from state and LOCAL taxes. And, in the case of I and EE bonds, you actually have a choice to report and pay federal taxes on the interest on an annual basis OR defer the tax until the bonds are cashed. What's more, you can switch from doing it one way to doing it the other way, subject to some limitations I'll explain if anyone's interested.

It doesn't seem like the interest compopunds tax free, like it does in a 401K...but at least you are paying the tax in future (infaltable) dollars...otherwise, why would anyone pay the tax currently, unless they are in a low tax rate?

nologic - Actually, the interest does compound tax-free like a 401K,,,,in the sense that taxes are paid when withdrawn. Remember that taxes are payable on the funds withdrawn from the 401K, its just that the contributions are deducted from currently payable taxes in the year they're made....which is really the only difference between the two instruments. Best wishes.

I think of my investments into savings bonds as much better than an after-tax contribution to an IRA. If I need the money, I can withdraw it with a small penalty.

NO NO No, this is totally false. There are numerous differences between investing in savings bonds and investing in a 401(k).

1). Savings bonds are free of state and local taxes by federal law and 401(k) withdrawals are NOT. Although and importantly, some states exempt a certain dollar amount of withdrawals from retirement accounts from state income taxation, depending on the withdrawer's age.
2). Premature withdrawals (prior to age 59 1/2) from 401(k)s are subject to a 10% penalty based on the entire withdrawal (subject to several exceptions, but the exceptions apply only to the penalty and taxation remains!), whereas premature redemptions (prior to 5 years from the month of purchase) of savings bonds are subject to a penalty of 3 months' interest (NO exceptions).
3). Contributions to 401(k)s are deducted from current INCOME, not current TAXES (bseller is confusing a tax DEDUCTION with a tax CREDIT; not the same thing at all), while purchases of savings bonds have no effect on income taxes at the time of purchase.
4). You cannot choose to report the increase in value of a 401(k) on a current basis, whereas you can with savings bonds.
5). Interest on savings bonds can be free of income taxation if used for educational purposes under certain circumstances, whereas 401(k) withdrawals NEVER are.
6). Savings bonds allow the holder to choose between tax deferral or current taxation and this valuable option is NOT available with 401(k) plans.
7). There are zero transaction costs involved with savings bonds. There are zero ongoing fees. There are zero bogus marketing costs (= "12-b1" fees that you have with some mutual funds in 401(k) accounts).
8). The value of EE savings bonds increases monthly, the value of I savings bonds adjusts monthly (possibly downwards in the case of deflation, although this has never happened YET), and the value of 401(k) assets fluctuates daily.
9). When one decides to redeem savings bonds, one knows with certainty how much one will get, whereas if one redeems 401(k)assets, one is at the mercy of the daily closing price, which is ALWAYS UNKNOWN at the time the redemption decision is made.
10). You can't get frequent flyer miles for 401(k) contributions but you can if you buy savings bonds with a mileage earning credit card.
11). You can't get any interest-free float on 401(k) contributions (in fact, the opposite occurs in most situations), but you can with savings bonds purchased with a credit card.
12). You can walk into any bank in any town and redeem savings bonds for immediate cash. Try that with your 401(k) = NOT.
13). You have to have earned income to contribute to a 401(k) plan; not so with savings bonds.
14). Even if you do ELECT to pay tax on redemption of savings bonds, the taxation is only on the increase in value. Every dollar withdrawn from a 401(k) is taxed, even if it has DEcreased in value (of course, you do get an up-front reduction in taxable income when you contribute to a 401[k] and you don't with savings bonds.)
15). Under certain circumstances, you can borrow against a 401 (k) account (although this is seldom a good idea IMO) and you can't do that with savings bonds.
16). 401(k) assets receive preferential treatment (cannot be seized) in bankruptcy in many states (most states I think, but would not swear to it and am not an attorney), whereas savings bonds do not.
17). You must begin to make mandatory minimum distributions from 401(k) accounts starting no later than age 72 and this is not the case with savings bonds.
18). You can buy up to $45,000 worth of savings bonds per social security number per year and this is the same for everyone; the limitations on 401(k) contributions depend on many factors and basically are different for each person. But, for the average person, the 401(k)limit will be far lower than $45,000.

And, to answer a previous poster, you might want to elect to report the interest income currently if you expected to be in a higher tax bracket in future years, compared to the bracket you are in right now. For example, you are in graduate school, you are a commissioned salesperson having a slow year, you have a large casualty loss, or many other possible scenarios.

BSeller, a very dangerous and inaccurate post!

Doakes

[This message has been edited by JoeDoakes (edited 07-10-2002).]

[This message has been edited by JoeDoakes (edited 07-10-2002).]

Joe Doakes - You are obviously correct about the many, many differences between bonds and 401k's and my earlier post was inarticulate when I said: "this is the difference between the 2 instruments"....

I had intended to imply that the difference (when related to nologic's question), related to the ability to reduce current income with contributions to an IRA, which is not available on bonds. My earlier post was also 'intended' to indicate that bonds do in fact, compound tax-free, like a 401k, which was what I understood nologic's question to be.

Mea culpa if others interpreted my poorly worded answer in terms of the differences between the instruments......there are clearly many differences between them as you've ably pointed out.

Best wishes.

I am probably wrong, but I thought when interest compounded tax free, that you earned interest on the interest ... whereas with Savings Bonds, I thought the interest was a set amount each year (not compounding and increasing each year)?

You are incorrect. Series EE bonds are sold at a discount to face value and the interest rate is applied to an ever-increasing amount. Series EE bonds have an initital maturity of 30 years; however, the government guarantees that they will at least double in value after the first 17 years. This is equal to an effective annual rate of (take the seventeenth root of 2.0 and subtract 1.0) 4.16% (rounded to two decimal places). After the 17th year, the government can change the terms for years 18-30. Series EE rates are determined by taking 90% of the average yield on marketable five-year treasury securities. So, although it is often said that EE bonds pay a "fixed" rate, this is not exactly true!

Series I bonds are more complex. They are sold at face value and there is an interest factor (fixed for the life of the bond) and an inflation factor (variable and determined twice a year). The inflation factor could in theory be negative for any given six-month period, so the interest could in fact be applied to a decreasing amount (although as I stated in my earlier post, this has never happened - yet. I bonds have only been around for roughly five years or so). However, you are guaranteed to receive your entire principal if held to maturity, even if there should be persistent deflation. Unlike EE bonds, I bonds' terms canNOT be changed over their thirty year life.

Hope this helps.

Doakes

This has been stated before but bears repeated.

Note, of course, that after the first six months, the bonds can be redeemed at accreted value minus the last three month's interest. Therefore, it's always possible to avoid the negative interest rate. This is not true of standard inflation-indexed bonds. The fact that rates are set on a lagged basis helps you avoid this problem as well. These two features are quite valuable embedded "options" of savngs bond.

And the overall interest rate will never be negative; if the inflation component is more negative than the fixed "real" rate, the adjustment will be held in abeyance until the inflation again "upticks." Mechanically, this is how they guarantee the full principal.

But actually, highgamma, you COULD "theoretically" still be exposed to a negative inflation component cuz it only adjusts every SIX months vs. the THREE month penalty (since the inflation adjustment is made in arrears rather than prospectively).

The option to "put" the bond back to the issuer on any banking day could be incredibly valuable and I know of no other instrument that provides this option WITHOUT exposure to intraday market fluctuations.

And miles too! What a country.

Sorry for the caps and don't mean to shout but too ignorant to figure out how to bold or italicize.

Question: If I buy a EE bond with a face value of $5,000 for a purchase price of $2500, how is the interest on this bond calculated?

Is it based on the face value (3.96% * $5,000) or is it based on the purchase price?

$2,500

Has somebody charged the purchase of Savings Bonds with the Amexco SkyMiles Credit Card in order to get 2 SkyMiles for 1 dollar?
Or is the purchase of Savings Bonds exempt of the 1 $ to 2 Miles exchange?

I have purchased US Savings Bonds on the card three times when they have offered double miles: late last year, during the month of June and currently during the July 15 to August 15 promotion period. Although they cap the number of bonus miles one can earn, it is still a very good mileage generator.

I don't think so from what I just read
on a credit card info website:

Two (2) miles for every dollar ($1) spent at stand-alone grocery stores, gas stations, drugstores, Delta Airlines, home improvement stores, the U.S. Postal Service, or when used to pay a wireless phone bill.
Read Terms and Conditions for more details.

So unless a lot of your purchases fall into those categories, most of your miles will be one for each dollar. A nice thought, though, if they'll ever let you do that.