By: W. Kirk Taylor, CFP® & Gaby S. Dominguez
What Are I Bonds?
I Bonds are a U.S. savings bond that are designed to protect your cash from the erosion of your purchasing power, i.e. inflation. With inflation running at a four-decade high, investors are naturally drawn to investments that offer inflation-beating yields. These days, I Bonds seem to offer investors the closest thing to a free lunch we’ve seen in years, as I Bonds offer a high return with virtually zero default risk……as they are backed by the full faith and credit of the U.S. government [2]. Note that there is a chance of default, but it would require the U.S. government to default on its obligations; something most investors consider to be a very, very small risk. The “I” in I Bonds stands for inflation.
The current interest rate for I Bonds is 9.62%., the highest it has been since May of 2000! This is because the interest rate for I Bonds are positively correlated with inflation. If inflation is rising, so are the yields on I Bonds. Steven Jon Kaplan from True Contrarian Investments points out that the yield for I Bonds “far surpasses” other government-guaranteed interest rates that are present at banks and brokerages [1]. However, you are only able to buy I Bonds at this rate through October 2022.
I Bonds are generally considered to be “safe” investments as they are issued by the U.S. Treasury. Since I Bonds are exempt from state and local income taxes, they are also attractive to high income individuals who are subject to state and local taxes.
On the government website, Treasury Direct, you can purchase up to $10,000 worth of I Bonds per calendar year. If you want to up the annual total, you can buy $5,000 of paper I Bonds, provided you have a federal tax refund coming your way.
How Do I Bonds Work?
The interest for I Bonds is computed through composite rates that are based on a fixed interest rate and on an inflation-adjusted rate. Interest is accrued and compounded twice a year.
The complex composite interest rate formula looks like this…
Composite Rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]
However, you must own the bond for at least five years in order to get all of the due interest. If you cash out an I Bond before holding it for a year, you will forfeit three months of interest [1]. Additionally, you are unable to resell I Bonds, meaning you have to cash them out with the U.S. government directly. They can be redeemed on the Treasury Direct website or cashed in at a local bank.
The maturity rate for I Bonds is 30 years. This is due to a 20-year original maturity period, then a 10-year extended maturity period.
Although they are exempt from state and local taxes, they are not exempt from federal taxes. You pay taxes at maturity or once the bond is cashed. Additionally, even if you receive an I Bond as a gift, you are still liable to pay the taxes on it. However, interest can be tax-exempt if the proceeds from the I Bond are used for higher education expenses.
Why Choose I Bonds?
I Bonds generally provide excellent protection against inflation, which today is at a four-decade high. Additionally, they can be a great compliment to college savings in 529 plans [1].
Although the $10,000 annual limit may seem less appealing at first glance, there are ways to buy more I Bonds! As an example, according to the District Capital Management, if you are a married couple filing jointly, you each have a business and one has a trust, then you are able to buy $55,000 in I Bonds, which is explained below:
$10,000 from Person A’s personal account
$10,000 from Person B’s personal account
$10,000 from Person A’s business account
$10,000 from Person B’s business account
$10,000 from Person A’s trust account
$5,000 from their tax refund
= a total of $55,000 in I bonds! [2]
The risk of diving into this loophole is that the interest rate may fall in the future if inflation falls to lower levels, as many expect. Consider the investment in the context of your overall risk tolerance, asset allocation and your long-term plan.
With that being said, here are four reasons to consider I Bonds:
- They are a wonderful inflation hedge. So, if inflation is up then the interest rate is up too.
- The federal government guarantees a 3% to 5% potential return.
- They are exempt from state and local taxes (not federal). However, interest can be tax-exempt if used for higher education expenses.
- The redemption value of your I Bonds is unable to decline.
If you want a safe investment backed by the full faith and credit of the United States government and one that protects your purchasing power from inflation, then consider investing in I Bonds!
As always, consult your tax advisor about the merits of I Bonds given your specific set of circumstances.
With our economy in a bit of turmoil and the prospects of a recession looming, I Bonds offers an attractive yield that may complement a traditional stock portfolio!
Footnotes:
[1] https://www.forbes.com/advisor/investing/what-are-i-bonds/