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.
- 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 deferred 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 deferred 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 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
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.
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.
- TreasuryDirect – I Savings Bonds Rates & Terms
- Savings Bond Advisor – Great site about US Savings Bonds
Readers what other investments would you use that are not specific to education, but can be used for education tax-free?