I Bond, You Bond, We all Bond
Okay, corny title, but I’m sure you’ve heard of I Bonds from somewhere as they seem to be the trending word in the world of finance right now in 2022.
If you haven’t already, I Bonds could be worth looking into. I Bonds are considered one of the safer assets since it’s backed by the U.S. government, and they can offer protection from your money losing value due to inflation. These are some great benefits for any investor looking for a place to park their money, however, there are some limitations the government has placed on I Bonds. This is probably because of the great benefits they offer. These limitations could play a factor in determining if I Bonds would benefit you. Let’s look at some information on I Bonds to help determine if they will be right for you.
What are I Bonds?
I Bonds (or Series “I” Bonds or “Inflation” bonds) are a type of savings bond sold by the U.S. Treasury. They can come in either paper or electronic form and are purchased from the U.S. Treasury's website. Any U.S. citizen, official U.S. resident, or United States government employee (regardless of their citizenship status) can buy and own I Bonds.
I Bonds are sold at face value with a minimum required investment of $25. Electronic I Bonds can be purchased in any amount at or above $25, however, the paper I Bonds can only be purchased in increments of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000.
Per the Treasury Direct website, you can only purchase up to $10,000 per calendar year per person, but there could be a few other ways to purchase additional amounts such as using a tax return to purchase paper I Bonds, or purchasing I Bonds for gifts or for custodial accounts for children.
How do I Bonds pay?
I Bonds earn two interest rates.
A fixed-rate - This is the rate you are locked in at when you purchase the bond. It is an annual rate, and this rate never changes as long as you hold the bond.
As of today (July 2022) the fixed-rate interest on I Bonds is at 0.00%.
The inflation rate - Per Treasury Direct’s website, this is the rate that changes every six months depending on the “non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy.” This is applied to the bond every 6 months after the purchase date.
As of today (July 2022) the inflation rate on I Bonds is at 4.81% semiannually.
The fixed-rate and inflation rate will be combined to give the earnings rate or composite rate. This will never be less than zero, but if there is deflation instead of inflation, this combination could cause this composite rate to be lower than the fixed rate.
As of today (July 2022) the composite rate on I Bonds is at 9.62%
Below is an example of the equation used to determine the composite rate on I Bonds.
I Bonds accrue interest monthly, but they do not pay that interest until the bond is matured or redeemed. The interest will also compound semiannually. (Compound means to earn interest on the principal amount plus on any previous interest earned.) When the I Bond matures, the investor will receive the face value of the bond plus any accrued interest.
I Bonds can accrue interest for 30 years or until you cash them out, whichever comes first, however, I Bonds are not redeemable for the first 12 months, and investors who redeem them within the first five years will forfeit the last three months of interest as a penalty.
Other considerations
Per Treasury Direct, the interest from I Bonds is exempt from state and local taxes, but it is subject to federal taxes in the year the bond matures or is redeemed. The interest is taxed as ordinary income rather than the lower capital gains tax. There may be some additional benefits if the interest is used to pay education tuition. There may also be an option to pay taxes each year on the interest earned that year, but there could be some disadvantages to doing this as well. Be sure to speak with your tax advisor on what options would be best for you.
Summary of the Pros and Cons of I Bonds.
Pros:
I Bonds are usually safer than stocks or corporate bonds because they are backed by the U.S. government.
The interest rate on I Bonds moves with inflation helping you maintain your purchasing power.
I Bonds could earn more in interest than savings accounts or other bonds can.
The tax exemptions at the state and local levels, as well as the federal exemption for tuition payment, could make I Bonds especially appealing for investors in higher tax brackets or for those with college-bound children.
Cons:
The money you put into an I Bond is locked up or not accessible for 12 months, and you will lose some of your interest earned if withdrawn before five years.
The purchase limit is $10,000 per year (potentially more depending on how the bond is purchased).
You must buy and hold them directly through the treasury direct website.
There is no guarantee that the interest rate on these will continue to stay high since the interest earnings portion is based on the CPI-U which is updated every six months. Also, if you want to move your money to something that will earn you more at the time, you could be penalized for doing so if it is within the first five years.
I Bonds are taxed as ordinary income rather than at the lower capital gains tax.
Investors looking to have a steady stream of income may not be fond of I Bonds because the earnings can only be redeemed after the bonds matured.
Could an I Bond investment be right for me?
Here are a couple of questions to ask yourself if you are considering investing in an I Bond.
#1 - Do you have a solid emergency fund?
The money put in an I-Bond will have stipulations, such as how long the money will need to stay in the account before you can withdraw it without penalties. As stated above, I Bonds are not redeemable for the first 12 months, and investors who redeem them within the first five years will forfeit the last three months of interest as a penalty. This means you will not be able to touch your money for at least 12 months, and then you could lose some of the benefits if you withdraw the money within the first five years. With this in mind, it could be a good idea to make sure you have some cash reserves or emergency savings in a separate account that you can easily access without penalties should you need if an emergency came up. This could be important, especially in the uncertain times of 2022.
#2 - Will the opportunity cost of setting up another account be worth it for you?
I Bonds offer much higher interest rates, however, there are limitations on how much you can deposit or buy. Be sure to do the math to decide if it would be worth the extra effort and complexity of this new account for you. If you are early in your financial journey and already have your emergency fund, then this might be a benefit for you. If you are later in your financial independence journey, then this amount might not move the needle of your portfolio much to go through the hassle with this extra account. This will all depend on the individual, so be sure to look at the math to decide if it would be worth it for you.
To calculate this, first find the interest amount you would receive with the I-Bond and then subtract it by the interest amount you would receive in another high-yield savings account. Take a look at this number, and decide if this amount will be worth the extra effort and complexity of opening this account along with making this money illiquid (or locked up) for a period of time?
Below are some of the links I used to find this information. If you are considering purchasing I Bonds, please check these out and do your own research to ensure you have accurate information, especially if you are looking into this later than 2022.
The Money Guy Show - Are I-Bonds the Best Way to Fight Inflation?
The Money Guy Show - Where is the Best Place to Park Your 3-6 Month Emergency Fund?
Let's Talk Money! with Joseph Hogue, CFA - Series I Bonds | Ultimate Guide to 9%-Plus Interest
Let me know what you think. Is there any other information to consider when thinking about I Bonds?
