Why I Like US I Savings Bonds

Lately I’ve been adding to our security investment bucket US I Savings Bonds, or I-Bonds for short. In my opinion, they are a great bond to invest in but are often overlooked. The advanced investor or investment adviser often pooh-poohs them. Maybe because they generate no commission from them.

They were created in 1998 as a method to keep up with inflation and are geared toward retail investors. I Bonds have some unusual and confusing aspects, so it’s best to understand them so you can use them to your advantage.

Composite Earnings Rates

I Bonds grow tax-deferred for up to 30 years and are free from state and local taxation. An I-Bond has two components, and they are added up to get the composite return:

  • Fixed Rate – Remains the same for the life of the bond. The fixed rate for newly issued I Bonds is announced on May 1 and November 1 of each year. The rate applies to all I Bonds issued during that six-month period.
  • Inflation Rate – Based upon CPI and is also announced every six months, on May 1 and November 1. This inflation adjustment applies to both existing I Bonds and newly issued ones, but the timing of that adjustment is dependent on the original issue date of any particular I Bond.

Fixed rates and semiannual inflation rates are combined to determine composite earnings rates. An I Bond’s composite earnings rate changes every six months after its issue date. For example, the earnings rate for an I bond issued in March 1999 changes every March and September.

If you would like to find the composite rates your bonds are earning, try the Treasury’s online Savings Bonds Calculator.

Here’s how the composite rate for I bonds issued May 2010 – October 2010 was set:

Fixed rate = 0.20%
Semiannual inflation rate = 0.77%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0020 + (2 x 0.0077) + ( 0.0020 x 0.0077)]
Composite rate = [0.0020 + 0.0154 + 0.0000154]
Composite rate = 0.0174154
Composite rate = 0.0174
Composite rate = 1.74%

Interest accrues monthly and compounds semiannually.

Terms

  • Starting 2012, paper bonds are no longer available. The only option is via a backdoor method. Overpay your taxes, and request it to be paid in paper I-Bonds. The limit is $5,000.
  • Electronic versions (through TreasuryDirect) are available, but a maximum $10,000 for each type per year per social security number.
  • They cannot be redeemed during the first year.
  • From 1 – 5 years, if you redeem them early, you’ll get a 3-month penalty of the interest earned.

Pros and Cons

The reasons I like US I Savings Bonds:

  • The interest generated is tax differed until you cash them out. No state or local taxes and only federal taxes are owed. They are perfect to use in taxable accounts as part of your bond portfolio. They can be a means to extend your tax differed accounts.
  • The fixed rate part of the bond is “fixed” for the term of the bond. If the fixed rate rises in the future, just cash it out for a newer higher rate bond.
  • They are multi-purpose since retirement accounts, 529 and alike are savings targeted for a specific goal.
  • If used for higher-education (college), no taxes are owed. The bonds MUST be in the parent’s name, not the child. There are other restrictions.
  • The total interest rate cannot be less than zero, even during deflationary periods.
  • Is more tax efficient than TIPS in taxable accounts.
  • Since you are buying direct from the US Treasury, there is no markup fee from a brokerage house.

The disadvantages:

  • The US government has currently a low fixed rate (0%), which isn’t as attractive as it was during the 2000′s. Fortunately, you can “upgrade” your I Bond anytime after one year. Though with budget deficits it’s doubtful they government will change the fixed rate anytime in the near future.
  • You trust the BLS to accurately reproduce the inflation rate.
  • The inflation rate is only adjusted two times a year. Should inflation run rampant, this may cause some lag.
  • No secondary market. To redeem all bonds they must be sold back to the US Treasury.
  • If held for a short period (5 years) and in a high tax bracket, it may offer poor returns after taxes.

I Bond Tips

$10k Limit
A common trick to get around the $10k annual limit per social security number is to have other family members purchase them in their name. Keep in mind if used for higher education, the I bond must be in the parent’s name so it’s tax free.

Keeping Track Of I-Bonds
Many families have bonds in their safe, safety deposit box, or somewhere scattered around the house. A little known application is available from TreasuryDirect that allows you to manage your savings bonds with ease. Their Savings Bond Wizard is a Microsoft Windows based application that allows you to enter, track and updates returns.  It will retrieve automatically the latest I-Bond rates. The Savings Bond Calculator, is a web based app that can do similar calculations to the Windows application but online.  The biggest disadvantage is it does not offer a method to save, so every time you wish calculate your returns, you must re-enter each bond.

When To Buy?
Buy US I Bonds the last day of the month. This is because the interest accumulated is the same either at the first or the last of the month. For the same reason, when selling you are best to sell at the beginning of the month.

I-Bonds Seriously?

Some may question my decision to invest in any US bond. You’ve all heard about the mile-high deficits, the muted inflation rate, talk of possible double-dip recession and/or Japan-like 20 year deflation cycle.

While a recession is not completely out of the question, in my opinion would not be as severe compared to what occurred in 2008. If we did get a long-term deflation death spiral, then at least the money invested would be the same as if I had kept it in cash. This doesn’t help us with education expenses, since it has been increasing double the rate of inflation.

The best case scenario, and I still think the most probable, is that higher inflation will occur than what we’ve seen the previous 30 years. At one point I-Bonds, had a much higher fixed rate, and a much higher annual limit ($60k) than currently. I am kicking myself now for not purchasing them 10 years ago, but I digress.

We are investing in I-Bonds because they can used for our children’s education, or for other expenses we may have in the future. We also have 529 accounts for our children, but I’m not completely sold on how effective they will be when they go to college. I would rather hedge our bets, in case one of them does not go off to college, and keep our savings options open to other investments for them.

Additional Information

Readers what other investments would you use that are not specific to education, but can be used for education tax-free?

Comments

    • says

      Good question. I have a few I bonds earning more than that currently.

      I-Bonds are
      - tied to inflation (yes I understand you can get out early with a CD, abit with a penalty)
      - can be used for higher education tax free (at least for now as there has been some talk about changing the tax rules on savings bonds)
      - not taxed until you cash out

      As I mentioned I missed out during the early 2000's with the great fixed rate and big limit amount. So I'm not investing a huge amount in them per year, but they are part of our portfolio. As of late, I've been investing in more corporate and muni bonds than I-bonds.

  1. mike says

    i-bonds sound good but the fact remains that all U.S government debt is overbought. So, the inflation protection is tied to an investment that has a low rate of return to begin with. (high price == low yield)

    Also, keep in mind that the inflation rate is determined by the same institution that issues the bonds. A conflict of interest. Does anyone really think that inflation is near zero right now? When i look at the goods that I buy, i say the answer has been no the past couple of years. WIthout even considering services like education and health care which don't count.

    i-bonds are good for that portion of your portfolio labeled 'capital preservation'.
    Mike

    • says

      Hi Mike,

      What do you recommend then that is flexible as I bonds in their use, keep up with inflation (at least what's reported by the BLS), and have the same tax advantages?

      I agree about government accurately reporting inflation, I've stated this a few times on my blog and tweets. Sites like Shadow Stats http://shadowstats.com/, which I subscribe to, offer an alternative (abit I also think flawed in some respects) viewpoint on inflation.

      In the end though can't you state that most bonds are about 'capital preservation'? Until a better option exists, I still think I bonds should be part of one's portfolio.

  2. micromillion says

    junkie,

    I could recommend a lot of different investments that have many of these advantages. I investigated these a bit more. I don't know of any investments that guarantee principal like these do and have the credit quality of Treasuries. So, these are really not like other Treasury bonds, since you always get your principal back even if you sell before maturity. If you redeem before 5 years, you sacrifice interest.

    Given the low interest rates now, you might still be better off selling and buying newer ones when rates go up even if you pay a penalty. So, these aren't as bad as I thought.

    • says

      After taxes say compared to a 1 year CD, ibonds are not that bad. Current I bonds yield 1.75%. Lets figure out their pre tax equal.

      http://www.dinkytown.net/java/TaxEquivYield.html

      If I invest in 10k and count NY state taxes (where I live) that is equivalent to 2.02% return beating a one year CD. Currently the highest 1 year CD is 1.76%.
      http://nowcdrates.com/1-year-cd/

      Granted if you sell early your return on an i-bond is less 3 months, the return becomes 1.52%. This assumes no federal taxes are taken out (if used for education purposes). Keep in mind they also have inflation protection (if inflation rears it's ugly head)

      I plan on holding our I bonds at least 5 years and more than likely 15 years. After the 5 year holding period though, I can pretty much do whatever is needed with the money to yield a higher return (including buying newer I-bonds)

      The longer I hold them the greater the real return.

      You also mention "U.S government debt is overbought.". Overall I agree, keep in mind with ibonds there isn't a secondary market to affect the pricing of these types of bonds. Granted the govt has made the fixed rate very low on purpose which is another issue. I Bonds overbought? They technically can't because there is no market to determine a current price on them (unlike say TIPS).

  3. jkwcivil says

    Good article. I-bonds are basically CPI indexed dollars, plus a little in most instances. They are better than cash after the first year.

  4. JT says

    Junkie,

    I totally agree with you that I Bonds are a great investment for a portion of the fixed income portion of a diversified portfolio. They certainly are more favorable than CD’s or bond funds at this point in the interest rate cycle. I have been purchasing I Bonds for over 10 years for myself and my grand children. I also use the Saving Bond Wizard to keep track of my inventory. You mentioned that there is no way to “save” the inventory and that you have to key in serial numbers each time you update values. I have not found this to be the case with the Wizard. I save my inventory each time I update values at the end of every month.

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