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I Savings Bonds are complex but rewarding

Q. In recent years, you have advised your readers that government I Savings Bonds offer a safe and rewarding investment.   I bought my first ones in 2000 and have been, until recently, quite pleased with the returns.

Currently, the inflation component has suddenly dropped to one percent, and I have not been able to find out the reason for this change.   The May 2006 CPI published by the Department of Labor Department was a tad over 3 percent, and for the preceding six months was in the range of 3.4 percent. Would you please explain the apparent discrepancy?   Is it possible that the Labor and Treasury departments use different statistics? --- F. J., by email from Wadsworth, OH

A. You'll be glad to know that the new rate, posted Nov. 1 and good for all bonds between now and May 1, is 3.10 percent, based on the annualized rate of inflation as measured by the CPI-U (Consumer Price Index for all Urban Consumers) as measured by the Department of Labor. Note that the Department of the Treasury uses the Department of Labor measure of inflation.

As a consequence, an I Savings Bond purchased between April 1 and Oct. 30 of this year will now earn a 1 percent fixed rate plus the 3.10 percent inflation rate, or 4.10 percent. A new I Savings Bond purchased in the current six-month earning period will be earning at a 1.4 percent fixed rate plus the 3.10 percent inflation rate, or 4.52 percent.

You can learn more about these bonds by visiting the savings bonds website at www.savingsbonds.gov/indiv/indiv.htm.   The only thing constant with these bonds is their fixed earning rate, which is fixed at the period of purchase. That rate is what you will earn until the bonds mature, plus semi-annual adjustments for the rate of inflation.

Savvy investors who bought the first I Savings Bonds late in 1998, for instance, earn a whopping 3.30 percent fixed rate plus the inflation rate. Those bonds are now earning over 6 percent. Since November 2002, however, the fixed rate has ranged from a high of 1.6 percent to a low of 1 percent--- plus the rate of inflation.

The rate of inflation in the previous period was very low--- only 0.5 percent, annualized to 1 percent---due to declining energy prices. The rate in the preceding 6 month period had been very high due to rising energy prices.

Basically, you should pay attention to the fixed rate in the period of purchase and know that the bonds will eventually reflect the rise in the Consumer Price Index plus the fixed rate.

Q. I am in my early 70s, retired, receive Social Security, have Medicare, and receive a required minimum distribution from my 401k account.   Working part-time, I generate some self-employment income. This income is subject to income tax. It also triggers tax on part of my Social Security earnings. And I pay the self-employment tax.  

I do not have any business expenses to write off against the self-employment income.   Do you have any suggestions for reducing some of this tax liability?   ----J. C., by email

A. Welcome to the future! What you are experiencing will be the lot of all younger workers, because the formula that triggers taxation of Social Security benefits is one of two items in the entire tax code that is not indexed for inflation.

The other is the dreaded AMT, alternative minimum tax.

Sadly, there is not much you can do. Most of the cures are worse than the ailment.

One potential cure, conversion of your qualified plan assets to a Roth IRA, will penalize you for withdrawals from the new account in the first five years. That's not something a seventy-something wants to do.

Just remember that this miserable bit of complexity is a bipartisan achievement. A Republican president (Ronald Reagan) signed it into law and a Democratic president (Bill Clinton) turned it into a graduated tax. This tax is the main reason young middle-income earners who once expected to retire to a lower tax rate can now expect to retire to a higher tax rate.

Comments

 

ABModerator03 said:

Does not JC need to also be aware that there is an adjusted gross income limit restriction? Is it not true that the AGI cannot exceed $100,000 even if he wanted to do the ROTH conversion? That may change in 2010 but I have not studied those changes.

Just a few thoughts.

Thanks again SB for your cries for federal TAX sanity!!!

  

From Scott Burns:

Yes, like most of our tax code, there is an AGI limit. There will be a window for unlimited conversions in 2010. It is not clear, however, that an unlimited conversion would be beneficial if the conversion puts you in an artificially high tax bracket.

I wonder if some CFPs would have worked on this for their clients? It would be good to hear from them.
December 21, 2006 9:00 AM
 

ABModerator03 said:

On January 24, 2006, your coplumn said that "The 1 percent basic rate bonds that are available today are yielding 6.73%" I purchased $10,000 on that day. The interest credited through today is $372.00, which is well below the rate stated in your column. I realize that the inflation-based comoponent is variable, but it is hard to believe that CPI has improved dramatically in the last year.

There is no way that I can find on the cumbersome Treasury Direct web site to figure out how they are calculating interest on my bonds or even how they do it in general. That site is incredibly user-horrendous.

Richard

  

From Scott Burns:

I agree with you about how frustrating it is to know anything about these bonds, largely because they have two moving parts--- their "real" yield which is set in the period you buy the bonds and their inflation yield, the inflation offset that is added to the principal of the bonds.

Here's the copy immediately above the sentence you quoted. I've added italic to the most important part:

How is the yield on I Savings Bonds determined? Every six months the basic interest rate may change. The basic interest rate is a premium that is added to the rate of inflation. Bonds purchased in the current period (November to April), are earning at a 6.73 percent annualized interest rate based on a 1 percent premium and a 5.70 percent inflation rate.

Bonds purchased in other periods will be earning at different rates because there were different basic interest rates in other periods. These rates varied from a high of   3.60 percent for bonds purchased in the May to October, 2000 period to a low of 1.00 percent for bonds purchased in the November 2005 to April 2006 period. Since the rate of inflation is added to each basic interest rate, ALL the I Savings Bonds issued in earlier periods are currently earning more than 6.73 percent. Bonds purchased in the May to October 2000 period, for instance, are currently earning a whopping 9.40 percent.

Why is the basic interest rate so much lower today than it was when the bonds were introduced?   Think of it as marketing. The bonds were new and unfamiliar when they were introduced in 1998. Today, people understand that the basic rate is a premium over the inflation rate.   The 1 percent basic rate bonds available today are yielding 6.73 percent, well over yields on bank CDs, tradable Treasury securities, and mutual funds that invest in government securities.
December 24, 2006 1:24 PM
 

ABModerator03 said:

Scott, I'm writing with respect to your column of December 24, 2006, in the Seattle Times. For a long time I've wondered how the fixed rate portion of the overall I-Savings Bond rate is determined. I haven't found the answer either at the savings bond web site or in your column. My guess would be that it is determined by some supply/demand reasoning, i.e. the government's demand for borrowed funds and their prediction of how much will be supplied by the public at various possible fixed rates. Is that correct or is there some other basis for the fixed rate?

Robert

  

From Scott Burns:

There is no published rationale so we'll have to speculate that it is some supply/demand process. History supports this since the bonds offered a 3.30 percent real return when they were first offered, making them a sure thing. Since then the real rate has declined as they appear to have sought the lowest real return they could provide and still have a positive flow of cash into the Treasury.
December 24, 2006 1:24 PM
 

ABModerator03 said:

I enjoy reading your column almost every day. I find your advise thought provoking and quite sound. Your column in the 12/25/2006 San Antonio Express-News has made me blink and write you this note to test my understanding.

The article I am referring to is your response to an email from"J. C.". In your response you wrote "One potential cure, conversion of your qualified plan assets to a Roth IRA, will penalize you for withdrawals from the new account in the first five years. That's not something a 70-something wants to do."

My understanding from reading the 2005 590 tax publication is:

(1) you are not subject to a penalty if you are over 59 1/2.

(2) Non-qualified withdrawals become taxable income only after you have withdrawn all of the contributions and/or conversion amounts.

If my interpretation is correct, I cannot see any downside to converting IRA assets to a Roth IRA after age 59 1/2. Of course the converted IRA assets are taxable in the year of conversion. Please Please correct me if I am wrong because I am 3 years into executing the very plan you suggest.

Thank you,

William

  

From Scott Burns:

My understanding is that when you convert you must wait 5 years before making any withdrawals, lest your withdrawals be subject to a penalty. Here's a URL: http://www.fairmark.com/rothira/taxfree.htm . Read under "Qualified Distributions" through the "5 Year Test".
December 25, 2006 8:47 AM
 

ABModerator03 said:

Regarding Roth IRA conversions. When Roth conversion amounts are withdrawn within a 5-year period beginning with the year of conversion, the amount withdrawn is subject to the penalty on eary distributions.

The amount of the withdrawal allocable to the conversion would not be taxable because taxes have already been paid on this amount. As for the early distribution penalty, since this man is 70 and since an exception to the early withdrawal penalty is being age 59 1/2, it seems to me he could also withdraw his converted amount penalty free.
December 28, 2006 8:26 AM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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