You may have caught a headline or heard some murmurers from colleagues about I Bonds and their currently high interest. If so, you’ve likely wondered how they have that interest rate in this market environment or if you should be using them.
Below we break down what I Bonds are and why you may or may not want to want to use them as part of your savings strategy.
What are they and how do they work?
I Bonds, or Federal Series I Savings Bonds, are unique in the way their interest rates are determined and paid. They are comprised of two components, a fixed rate and a semi-annual inflation rate:
The fixed rate doesn’t change from the time of purchase and stays the same throughout the life on the bond. Currently, the fixed rate is 0% for bonds purchased until October.
The semi-annual inflation rate can change every six months (May and November) and is based on the inflation rate, measured by CPI-U. The increase in inflation has made these rarely used savings bonds more attractive now. The current semiannual inflation rate is 9.62%
Together they make the composite rate which the bond would pay. The 0% fixed rate and 9.62% semiannual inflation rate combined bring the composite rate to 9.62%.
This rate would pay for 6 months, then will be reset to current inflation rates. For example, if year over year inflation dropped to 1% in the next six months your new rate would reset to 1% six months after purchase. If inflation is negative the rate cannot go below 0%.
So, what are the other considerations in using I Bonds?
- Inconvenient to access: There’s a slight “return on hassle” as you must have a separate account through Treasury Direct. You can’t hold these within another type of account.
- Limited liquidity and redemption rules: You can’t access these funds in less than a year. Between a holding period of 1-5 years you can redeem them, but you would forfeit the last 3 months of interest earned. After 5 years they can be redeemed for current value.
- Limits to purchase: Purchases are limited to a max of $10,000 per person, per year. There is also a minimum purchase requirement of $25 for electronic bonds.
- See link below for a detailed description on Treasury Direct’s Website. https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm
What about the tax implications?
- I Bonds have a 30-year life and you have the option to pay federal income taxes annually on interest or wait until you withdraw the funds, which is more common.
- Savings bonds are exempt from state taxation, except for estate or inheritance taxes.
- Interest earnings may be excluded from Federal income tax when used to finance education (income limits and other exclusions apply).
Are they right for me?
You can think of these as a supplement to your savings account rather than as part of your investment portfolio. With a fixed rate of 0%, I Bonds are not going to exceed inflation over the short or long term. Historically, that is a job for stocks and reinforces why they have an important place in your portfolio. I Bonds may be a good option if cash would otherwise be sitting in savings for several years without needing to be accessed. There is always the risk that inflation rates decline, and I Bond rates drop below those of a high yield savings account.
When contemplating these situations, it is important to refer back to your financial plan as your building block for savings, cash flow, and investment decisions. If you don’t have a financial plan in place, contact us on how we can help.