Quirky HH bond's days are numbered: Here's what to do

PERSONAL FINANCE

January 18, 2004|By EILEEN AMBROSE

FOR MORE than 20 years, people have invested in HH savings bonds as a way to delay paying income taxes and get an income stream to boot.

Now, in the name of progress, the quirky bond's days are numbered.

The Treasury Department said it plans to stop issuing new HH bonds by midyear, although no date has been set.

"We're basically going all electronic," explained Stephen Meyerhardt, a spokesman with the Treasury's Bureau of the Public Debt.

The HH bond doesn't easily fit that goal, and the small volume of the bonds didn't justify the expense of including them in the electronic system, Meyerhardt said. HH bonds make up $13.3 billion of the more than $200 billion in savings bonds.

Outstanding HH bonds won't have to be redeemed until they mature. Still, those counting on HH bonds are left to explore alternatives. And while there are several options, none is quite like the HH.

HH bonds differ from other U.S. savings bonds in a couple of ways.

For one, they don't accrue interest on a tax-deferred basis like their cousins, the Series EE and I bonds. HH bonds pay out interest every six months, and that income is federally taxed in the year it's earned.

On top of that, HH bonds aren't purchased with cash. Investors acquire the bonds in exchange for Series E and EE savings bonds for a minimum amount of $500. The benefit of this is that any interest accrued on the E and EE bonds won't be taxed as long as the money stays in HH bonds. The income tax bill comes due when HH bonds are redeemed or reach maturity in 20 years.

Essentially, an investor with an EE bond that matures in 30 years could postpone income taxes on the interest income for as long as 50 years by converting to an HH bond.

Today, investors are mostly interested in HH bonds to defer taxes, experts said.

"They used to be good for income," said Daniel J. Pederson, author of Savings Bonds: When to Hold, When to Fold and Everything In-Between.

Last year, though, the annual interest rate on HH bonds dropped from 4 percent to 1.5 percent. (Older HH bonds, acquired between February 1994 and December 2002, will keep paying 4 percent until they are 10 years old, and then they will drop to the lower rate for another 10 years, Pederson said.)

So what's an investor to do?

Some financial planners suggest HH bondholders earning 1.5 percent might consider cashing them in because the rate is so low.

"The return on these bonds is less than inflation. Just because you are not paying tax, inflation is eating away at the value of this money," said Jerry Cannizzaro, a financial planner in Oakton, Va.

Before doing that, though, weigh the tax consequences, which can be big tax bills in some cases, Pederson advised. Taxes can't be avoided forever, but it may make sense, for example, for those who know that their income tax rate will be falling soon to postpone redemptions until then and lessen the tax bite, he said.

Also, HH bondholders still earning 4 percent and happy with that rate can put off that redemption decision until the bonds reach their 10th birthday, and the rate drops, Pederson suggested.

For investors whose E bonds mature in, say, 2005 or 2006 and who had planned to convert to HH bonds to defer taxes, the decision gets more difficult, Pederson said. Do you get rid of an E bond earning 2.5 percent to 4 percent ahead of schedule and exchange it for the lower-interest HH bond while you still can? Pederson asked.

Investors may decide to do this, although they lose some interest, because it gives them more years to decide when to redeem the HH bonds and pay the tax bill, he said.

Once no new HH bonds are being issued, investors will have to consider alternatives.

Among them are the other savings bonds, the EE and I bonds.

"They can be a nice way to save and a good alternative to money market and savings accounts," said Jonathan Murray, senior vice president of investments with Legg Mason Wood Walker in Baltimore. He favors the I bond, which offers a hedge against inflation.

"Everybody is saying inflation is dead. It's not," Murray said. "The forward-looking investor would be smart to hedge their portfolio against the possibility of rising inflation and I bonds are a nice way to do that."

Right now, I bonds pay an interest rate of 2.19 percent. That's composed of a fixed rate of 1.1 percent for 30 years, plus a rate tied to inflation that's adjusted twice a year.

"I give a little edge to the Double E bond," and not because the EE bond's interest rate is a higher 2.61 percent, Pederson said. The EE bond over the past dozen years has earned an average of 2 percentage points above inflation, better than the I bond's 1.1 percent guarantee over inflation, he said.

If safety and inflation are concerns, consider Treasury Inflation Protected Securities, or TIPS, some experts suggest. These 10-year government bonds pay a fixed rate of interest every six months. Additionally, the principal is increased each year for inflation.

One drawback is that you don't collect the bump-up in principal until the bond matures, although you have to pay taxes on it every year. That's why some recommend holding these bonds in tax-deferred accounts.

Another option is bond mutual funds. These don't have the backing of the U.S. government, like TIPS and savings bonds. So it's possible for investors to lose principal in bond funds.

Safety-conscious investors might want to check out a fund investing in short-term government bonds, Cannizzaro said.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose @baltsun.com.

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