By Nancy Dunnan

(MONEY Magazine) – -- The good points of Series EE savings bonds are well known: backed by the U.S. government, they are risk-free, inexpensive and easy to buy. The price of this safety and convenience is also well known: savings bonds pay lower yields than are available elsewhere. Yet the returns on these bonds may be more attractive than you think, since the interest is free from state and local taxes. In addition, starting next month, many middle-income families that buy EE bonds to save for a child's higher education will get a federal tax exclusion too. For people who qualify for the maximum federal break and live in high-tax states, the current 6.98% EE bond yield would be the equivalent of 10.54% on a taxable investment. Five-year bank CDs, by contrast, currently pay an average of only 8.14%. Figuring out a U.S. Savings Bond's taxable equivalent yield to you, given your tax circumstances, takes some doing, but the worksheet on this page should help. Indeed, considering that they are supposed to be Everyman's investment, savings bonds are surprisingly complicated, and the new federal tax break adds to the complexity. ''At first flush, the new provision looks like a great deal, but people need to be aware of certain limitations before they jump in,'' says Kevin Beaumont, a tax consultant at Price Waterhouse in St. Louis. You can buy savings bonds at most banks, from all Federal Reserve Banks and their branches, through employers' payroll-deduction plans and by mail from the Bureau of the Public Debt, Parkersburg, W.Va. 26106. Sold at 50% of face value, bonds are available in eight denominations ranging from $50 to $10,000. Savings bonds do not pay out interest periodically but rather let it accrue. Bondholders can defer any federal tax they owe until the bond is redeemed, when the difference between the purchase price and redemption amount is taxed as income. If you hold them five years, savings bonds pay a variable rate equal to 85% of the rate on five-year Treasury notes or 6% -- whichever is higher. New rates are announced every Nov. 1 and May 1.

Because their rate fluctuates, it is impossible to know when an EE bond will reach face value. At worst, it would take 12 years, assuming the minimum return of 6%. The bond will reach face value sooner, however, if the rate at any time is above the minimum. If the yield were to remain at the current 6.98%, the bond would reach face value in 10 1/2 years. But you do not have to wait until a savings bond reaches face value to redeem it -- nor are you required to redeem it at that point. You can cash in any time after six months, although you receive reduced interest during the first five years -- as little as 4.16% on bonds held less than a year. Or you can let an EE bond compound untaxed for up to 30 years. Your redemption check would then consist of the full face value plus additional interest. A bank or S&L can tell you the current redemption value of your bond. You can also get free redemption value tables for bonds with face values of $50 from the Bureau of the Public Debt. For other denominations, send $1.75 ($3.25 for Series E bonds, which were issued before June 1980) to the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C. 20402. Not all families saving for kids' college are entitled to the new federal tax exclusion. Those couples with a modified adjusted gross income -- adjusted gross income that includes such items as Social Security and other retirement income -- below $60,000 ($40,000 for singles) pay no taxes on savings bond interest. But for couples with incomes higher than that, a declining portion of the interest is federally tax-exempt. Above $90,000 ($55,000 for singles), the tax break disappears. Worse, eligibility is determined by your income level when you cash in the bonds, not when you buy them. Thus in the happy event that your income outpaces inflation, you may end up with an unexpected tax bill. ''You could faithfully sock away cash in bonds while your child grows up and then be over the income limit,'' warns Edward Mendlowitz, a New York City certified public accountant. ''In effect, you would be punished for industriousness.'' In addition to meeting the income test, parents must hold the bonds in their own names, not the child's. Further, the proceeds can be used only for tuition and such expenses as lab fees -- not room and board. What if your child decides to run off with the circus, skipping college entirely? The bonds, alas, become federally taxable. Like any savings bondholder, however, you can roll over the money into Series HH bonds. These bonds pay out fixed interest semiannually -- a dismal 6% that is federally taxable in the year in which you receive it. But your Series EE bond interest can be absorbed into the Series HH bond's principal, where it will remain untaxed until redemption -- as long as 20 years.

BOX: What to Do

Custom-calculating a comparable yield The following formula will help you determine what you personally would need to earn on a fully taxable investment to beat the yield on a savings bond. The formula assumes that the interest rate on savings bonds and your tax bracket will remain the same. The example assumes state and local taxes of 6% and modified adjusted gross income (AGI) of $70,000 a year.

Source: Price Waterhouse