Mini-Course Series - Income (Part 2) by Institute of Business & Finance

MINI-COURSE SERIES

RETIREMENT INCOME Part II

RETIREMENT INCOME

U.S. SAVINGS BONDS The Treasury is currently issuing Series EE and Series I Savings Bonds. Series EE and Series I Bonds are accrual bonds; they accrue interest monthly, which is compounded semiannually. The interest is added to your investment every month, but you do not get the cash until you redeem the bond. Series EE Bonds are sold at a discount and mature at face value or higher; the difference in value is the variable interest rate you have earned. You buy Series I Bonds at face value and have a fixed interest rate adjusted for inflation and added to face value. In contrast, Series HH Savings Bonds are current income securities; interest is paid directly into a bank account every six months. The Treasury stopped issuing HH Savings Bonds in 2004.

Series EE Savings Bonds The purchase price for Series EE Bonds is one-half face amount. You can buy Series EE Bonds for as little as $25. It is a great way to make people think you are spending more money on their kids because they see the face value and may not know what you really spent. Series EE bonds are sold in increments of one penny for $25 or more. For example, you could buy a $60.50 (face value) EE Bond for $30.25. As you hold these bonds, interest is added to the amount originally paid. When you cash in Series EE Bonds, you receive the amount you invested as well as the compounded interest earned. Series EE are sometimes called zero coupon or discount bonds. Only $10,000 in EE Bonds ($20,000 face amount) may be bought in any one calendar year by/for any person. Series I has an annual limit of $10,000; however, it is computed separately from Series EE bond purchases. After 12 months you may redeem an EE or I bond for its current accumulated value; however, if you have not held the bond for five years you must pay an early redemption penalty equal to the last three months’ interest. You do not receive interest earned until you redeem the bond. Each month the interest is added onto the previous month’s redemption value. A benefit of an accrual bond is the interest is reinvested internally, automatically compounding. Furthermore, both EE and I Bonds earn more of a return than stated relative to other bonds because you are compounding earnings tax-free since you do not pay taxes on the interest until redemption. Series EE’s variable interest rate is set for all Series EE Bonds in May and November at 90% of the five-year Treasury note’s average yield over the previous six months. Each bond will reset to this new rate on the next six-month anniversary of its issuance. The bond’s redemption value on that date is also the one used to compute the interest for six months. For example, if you buy a savings bond in July, it will earn the rate set the previous May for six months (from July until January); the rate does not change in November when the new rate is set—it will be reset to November’s rate in January. It will then reset every six months thereafter. PART II

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RETIREMENT INCOME

Since an EE Bond’s interest rate changes, it is unknown how long it will take to reach the face value (2x your money). For example, a bond earning an average of 5% would reach face value in 14.5 years, while a bond earning 6% would reach its face value in 12 years. The final maturity is 30 years after issuance. This is when the bond stops earning interest. You are responsible for turning in the bond at that time to receive the amount you originally invested and all the compounded interest you have earned. If you have been postponing paying taxes on the interest now, this is when you do so.

Original Term for Series EE Savings Bonds Issue Date

Original Term

Issue Date

Original Term

01/1980 to 10/1980

11 years

11/1986 to 2/1993

12 years

11/1980 to 4/1981

9 years

3/1993 to 4/1995

18 years

5/1981 to 10/1982

8 years

5/1995 to 5/2003

17 years

11/1982 to 10/1986

10 years

6/2003 to present

20 years

Series I Savings Bonds The I Savings Bond program was started on September 1st, 1998. The main purpose behind these new 'I' bonds was to protect the investor from inflation. I Bond rates are announced every May 1st and November 1st. If that day falls on a non-working day, rates are announced on the next working day. Series I Savings Bonds offer a guaranteed fixed rate; interest is adjusted to keep pace with inflation—earnings’ purchasing power is protected. It is actually more accurate to say I Bonds pay a fixed real interest rate. Series I, like Series EE, is an accrual bond—the interest is added to the bond value monthly and not paid out until the bond is redeemed. Series I is different from Series EE in that you purchase it at its face value, not at a discount—you pay $50 for a $50 I bond. The value then increases monthly by the interest amount. The value of Series I Bonds also increases with inflation or decreases with deflation. So while the interest rate is fixed, the amount of money earning interest changes with inflation. It also grows with reinvestment and compounding. Therefore the number of current dollars your bond earns changes every six months. The last time the U.S. experienced deflation was 1954, when the annual rate of inflation was -1/2%. The semiannual inflation rate is announced in November and May; it is based on what inflation was the previous six months. Even principal is inflation adjusted; the Treasury releases a composite rate to help you know what your money is earning (the fixed interest rate adjusted for inflation). Actual total return will be higher because the composite rate does not reflect the compounding effect or the fact earnings are growing tax-free. PART II

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RETIREMENT INCOME

I Bonds vs. EE Bonds I Bonds

EE Bonds

Denominations

Paper certificate: $50, $75, $100, $200, $500, $1,000 and $5,000

Can be bought in increments of one penny for $25 or more. For example, you could buy a $50.24 bond for $25.12.

Purchase Price

Face value

50% of face

Purchase Limits

$5,000 per Social Security number; but another $5,000 in paper form (only available via an IRS tax refund)

$10,000 per Social Security number

Interest Earnings

Fixed rate based on variable semiannual inflation adjustment on principal; interest compounds semi-annually for up to 30 years

Fixed rate if issued after May 2005; interest compounds semi-annually for up to 30 years

Redemption

Redeemable after 12 months

Early Penalties

3-month interest penalty if redeemed during first 5 years

Taxes

Exempt from state and local taxes; may be tax-free for education expenses

Because of the attractiveness of earning a guaranteed return over and above the inflation rate, one would expect the I Bond to offer a lower interest rate than other bonds whose earnings are not protected from inflation. For example, Series EE Bonds issued from May until November 2002 earned 4.0%, while I bonds issued during the same period were assigned a fixed rate of 2.0% with a 2.6% composite rate. However, this is not always the case because the Treasury uses different formulas for computing rates for the different types of savings bonds and may sporadically change these formulas. At times, I Bonds can yield more. Also, if deflation is expected, the fixed rate for new I Bonds could be higher than new EE Bonds because at that time the I Bonds would be judged to be more risky—the risk being a declining redemption value and interest payout. However, if there is a period of deflation, the Treasury will not decrease a bond’s value below the most recent redemption value. With Series I Bonds as with Series EE, all interest earned since inception is compounded every six months from when you bought the bond. This is done automatically without you having to reinvest the interest—another advantage of accrual bonds.

PART II

IBF | MINI-COURSE SERIES

RETIREMENT INCOME

EE and I Bonds are sold electronically in any amount of $25 or more, including penny increments; the purchase limit for both types of bonds is $10,000 per calendar year per Social Security number. Paper I Bonds are offered in seven denominations, ranging from $50 to $5,000. You can purchase an additional $5,000 in paper I Bonds each year using your IRS tax refund. Like EE Bonds, I Bonds have the same purchasing limit of $10,000 per calendar year as Series EE; however, since the limit is computed separately from the limit on Series EE purchases, you could invest $10,000 in Series EE ($20,000 face value) and another $10,000 in I Bonds per Social Security number per year (plus another $5,000 in paper I Bonds using your IRS tax refund). Bonds sold before five years are subject to a threemonth earnings penalty.

Series I Bonds Fixed Rate Issued

Rate

Issued

Rate

Issued

Rate

5/1998 to 10/1998

3.4%

11/2001 to 4/2002

2.0%

5/2006-10/2006

1.4%

11/1998 to 4/1999

3.3%

5/2002-10/2002

2.0%

11/2006 to 4/2007

1.4%

5/1999 to 10/1999

3.3%

11/2002 to 4/2003

1.6%

5/2007 to 10/2007

1.3%

11/1999 to 4/2000

3.4%

5/2003 to 10/2003

1.1%

11/2007 to 4/2008

1.2%

5/2000 to 10/2000

3.6%

11/2003 to 4/2004

1.1%

5/2008 to 10/2008

0.0%

11/2000 to 4/2001

3.4%

5/2004 to 10/2004

1.0%

11/2008 to 4/2009

0.7%

5/2001 to 10/2001

3.0%

11/2004 to 4/2005

1.0%

5/2009 to 10/2009

0.1%

11/2001 to 4/2001

2.0%

5/2005 to 10/2005

1.2%

11/2009 to 4/2010

0.3%

5/2001 to 10/2001

3.0%

11/2005 to 4/2006

1.0%

5/2010 to 10/2010

0.3%

Education Tax Exclusion The savings bond education tax exclusion permits qualified taxpayers to exclude from their gross income all or part of the interest paid upon redemption of eligible Series EE Series I Bonds issued after 1989, when the bond owner pays qualified higher education expenses at eligible institutions. There are seven rules the government requires be fulfilled prior to being able to qualify for education tax exclusion for savings bonds: [1] Education expenses must be incurred same tax year bonds are redeemed. [2] You must be at least 24 years. [3] When for child's education, bonds registered in your name and/or spouse's. [4] When used for your own education, bonds must be registered in your name. [5] If you are married, you must file a joint return to qualify for the exclusion. [6] You must meet certain income requirements (listed below). [7] Post-secondary school must meet the standard for federal assistance. PART II

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RETIREMENT INCOME

Qualified Expenses Qualified educational expenses include: 

Tuition and fees (such as lab fees and other required course expenses).  Expenses benefiting you, spouse or dependent you claim an exemption.  Expenses paid for course required as part of degree or certificate program.  Expenses for sports or hobbies qualify if part of a degree or certificate.

Books and room and board are not qualified expenses. The amount of qualified expenses is reduced by any scholarships, fellowships, employer-provided educational assistance or other forms of tuition reduction. You must use both the principal and interest from the bonds to pay qualified expenses to exclude the interest from your gross income. If the amount of eligible bonds you have cashed during the year exceeds the amount of qualified educational expenses paid during the year, the amount of excludable interest is reduced pro rata. For example, assume bond proceeds equal $10,000 ($8,000 principal and $2,000 interest) and the qualified educational expenses are $8,000; you could exclude 80% of the interest earned, which would equal $1,600 (.80 x 2000 = $1,600).

Income Limits The full interest exclusion is only available to married couples filling joint returns and to single filers. Modified AGI includes the interest earned under a certain limit in each case. These income limits apply in the year you use bonds for educational purposes, not the year you buy the bonds. Exclusion benefits are phased out for joint or single filers with modified adjusted gross income that exceeds the limit. Full instructions and limits are outlined on IRS Form 8815. For 2012 single taxpayers, the tax exclusion begins to be reduced with a $71,100 modified adjusted gross income (MAGI) and is eliminated for MAGIs of $86,100 and above. For 2012 taxpayers filing jointly, the tax exclusion begins to be reduced with a $106,100 modified AGI and is eliminated for MAGIs of $136,100 and above (source: IRS.gov). Each year, IRS Publication 970 (or its “Correction”) lists income limits for educational purposes. Savings bonds cannot be posted as collateral for a loan.

PART II

IBF | MINI-COURSE SERIES

RETIREMENT INCOME

THINGS TO DO 

Your Practice

Find out the current yield for new Series EE and Series I Bonds. In the case of Series I Bonds, add an additional 300 basis points (the long-term historical inflation rate) to the yield and compare this Treasury bonds maturing in 14-20 years. Review the tax status of your clients with children to determine which ones might qualify for the tax-free status of these instruments when used for educational purposes. 

The Next Installment

Your next installment, Part III, covers five topics: U.S. Treasurys (including TIPS and zero-coupon bonds) plus investment grade and high-yield corporate bonds. You will receive Part III in a few days. 

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

PART II

IBF | MINI-COURSE SERIES