I Bonds? Yes Please.
Full article updated in December 2021
Update as of May 2023: The new variable rate for I Bonds fell from an annualized 6.89% from November 1 to April 30, to an annualized 4.30% as of the 5/1/2023 reset.
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U.S. Series I Savings Bonds (aka "I Bonds") are making some waves in financial circles.
Why, you ask? Let’s see if we can unpack it a bit.
(By the way, the numbers below are specific to the years 2021-2022, but many of the concepts apply generally speaking, so you’ll hopefully get something out of this even if you’re reading it much later.)
First, what are I Bonds?
I Bonds are U.S. government-issued savings bonds, formally known as U.S. Series I Savings Bonds.
The “I” in their name refers to inflation.
The idea is that these bonds essentially “track” inflation, so that they don’t lose value over time. Generally speaking, if inflation is going up by 4% per year, I Bonds will earn at least 4% per year. If inflation is 0%, I Bonds will earn at least 0%.
Nerd’s note: Technically speaking, the rate the bond pays is the inflation number PLUS a fixed rate that’s applicable for the life of the bond. You don’t need to worry about that too much as of December 2021, because the fixed rate of bonds issued now is 0%. So any bonds issued now would pay only the inflation adjustment, which changes every 6 months, as described below.
Of course, it’s a lot more complex than that, but that’s the basic idea. There’s a link at the end of this article where you can learn more about the specifics.
Why should I care?
You may be hearing a lot of noise right now about inflation. It’s running relatively high, which means anything that isn’t “keeping up” with inflation will lose its value over time. The higher the inflation rate, the more value lost.
With inflation readings being higher lately, that has been translating into higher interest rates on I Bonds.
For example, I Bonds issued between November 2021 and April 2022 have been paying an annualized interest rate of 7.12%.
That’s a really high rate for something so safe, as U.S. savings bonds are fully backed by the U.S. government. They are pretty much the safest investment out there.
Wait, can we come back to that interest rate?
If you have been following interest rates lately, you’ll recognize that 7.12% is a really high number.
For example, other super-safe options pay much less right now (as of December 2021):
Most checking accounts pay like 0.01%.
The highest rate paid by online savings accounts is around 0.50%-0.60%.
10-year U.S. Treasury securities pay around 1.40%.
Of course, the stock market has been returning way more than 7.12% for the past few years. But stocks are also inherently risky. They can return 30% one year and lose 30% the next. So they are in a completely different category from I Bonds, as they can’t promise any measure of safety.
Ok, I’m interested. How does this work?
Let’s get into the potentially-boring stuff.
When you buy an I Bond, you receive the initial interest rate (in effect at the time you purchase) for 6 months. After that 6-month period, you start receiving the next interest rate for the following 6 months. After that, you’ll receive the next interest rate for the next 6 months, and so on.
This pattern continues until you redeem (sell) the bond, or at most for 30 years. After 30 years, the bond won’t earn interest anymore.
As interest is earned, it gets added to the value of the bond at the end of each 6-month period (which creates a “compound interest“ effect over time). The interest isn’t paid out to you until you redeem the bond.
For example, if you buy an I Bond in February 2022:
You’ll receive a 7.12% annualized rate from February 2022 through July 2022.
By the way, the word “annualized” means that’s the rate over 12 months. But you’ll receive it for 6 months. So the true amount of interest you’ll receive during that 6 months is 7.12% divided by 2, or 3.56%.
The next rate will be set by the Treasury on 5/1/22. You’ll receive that interest rate from August 2022 through January 2023.
The next rate will be set by the Treasury on 11/1/22. You’ll receive that interest rate from February 2023 through July 2023.
And so on until you redeem (sell) the bond. Or for 30 years at the most.
Are there any other advantages?
Yeah, I Bonds are tax-advantaged in a few meaningful ways:
If your state of residence has a state income tax, you don’t have to pay it on the interest you receive.
You DO have to pay state income tax on most other interest income, so this is a pretty cool benefit.
This is especially enticing if you live in a state with a higher income tax rate, such as California, Hawaii, or New Jersey.
You have to pay Federal income taxes on the interest, but you can defer paying it until you redeem the bond. So instead of paying interest each year as it accrues, you can save that money that would go toward taxes until later when you actually receive the money from the bond.
Note: You also have the choice of paying the interest each year if you’d prefer. This could be useful if you’re in a lower tax bracket now than what you expect your tax bracket to be when you redeem the bond. It’s nice to have this flexibility.
If you use the money from the I Bond interest for educational purposes, you may not even have to pay Federal income taxes. However, this applies only if your income at the time you redeem is below certain thresholds, as this tax break isn’t meant for higher-income folks.
So, what’s the catch?
I Bonds aren’t perfect. There are some material downsides:
Your money is locked up for 1 year. That is, if you buy an I Bond, you can’t redeem it and get your money back for an entire year. This could be a problem if an emergency occurs and you need the money.
If you redeem the I Bond within the first 5 years, you’ll forfeit the previous 3 months of interest. This isn’t the end of the world, but it’s a downside.
If inflation goes down, I Bonds may pay very low interest rates. That’s because I Bond interest rates change every 6 months, following inflation. This is more than theoretical, as there have been 6-month periods in the past where I Bonds have paid 0% interest.
The good news is that the interest rate can’t go negative. If the inflation rate goes below 0% (aka “deflation”), the I Bond interest rate won’t go below 0%.
There’s a limit to how much you can purchase. The limit is $10,000 per person, per year. This isn’t an issue for most people, but if you have a higher net worth, then you’ll need to decide whether this limitation makes it “worth the trouble” of setting all this up. A few comments about this:
The $10K limit is per person (technically per Social Security number). So a married couple can buy up to $20K per year.
If you have a trust (like a revocable living trust), the trust can buy an additional $10K per year, even if the trust uses the same identifying number as you (that is, your Social Security number).
If you own a business, the business can buy an additional $10K per year, as long as the business has an EIN.
You can also purchase I Bonds for other people as gifts, up to $10K per gift recipient per year. Those bonds will sit in your account until such time you actually gift them to the person (which can be years later). In the year of the gift, it will count toward the recipient’s $10K annual limit.
Technically speaking, each individual can purchase an additional $5K per year, by directing a portion (or all) or their Federal tax refund to purchase I Bonds by using IRS Form 8888. These bonds would be issued in paper (!) form. You can, however, then exchange them into electronic form using the SmartExchange function on the TreasuryDirect.gov website.
The TreasuryDirect.gov website, where you purchase I Bonds, isn’t exactly user-friendly. The signup process is clunky and can be confusing.
It’s another login for another financial website. So there’s a hassle factor there. I suppose there’s also a risk that you could forget it’s even there, as it won’t import into other financial software you may have.
Are I Bonds a good gift idea for kids?
I have mixed feelings about this.
On one hand, sure, an I Bond is a nice gift for a child to be able to “put away” for a while and enjoy the proceeds later. It’s nice and safe, and there’s some historical precedent there, as parents and grandparents have been doing this for decades.
On the other hand, I Bonds probably aren’t the best investment for long-term growth, which is exactly what would benefit a child the most. If you’re buying a financial asset for a child, it would make sense to me to purchase something with higher growth potential, such as a stock mutual fund or ETF.
Should I buy?
I think I Bonds can be fantastic for many people, and not a great idea for others. It completely depends on your financial situation.
But I think they are definitely worth exploring further and considering for your situation.
I’d like to learn more!
If you’d like to get further into the details and/or if you’d like to move forward with purchasing, you can go to the government’s page at TreasuryDirect.gov.