Why You Should Consider I Bonds

Inflation is Here

Prices have gone up by 8.6% over the past 12 months (ending March 2022) as measured by the consumer price index (CPI). While inflation is not a new obstacle for the U.S. markets, the rate of increase at present has not been experienced since the early 80s. This dramatic shift in rising prices has begun to ripple through the economy, prompting the Federal Reserve to map out a plan to temper the supply-demand imbalance fueling these inflationary pressures. The Fed has specifically stated two main avenues in pursuit of its objective:

  1. Reducing the bond purchase program initiated during the global pandemic
  2. Increasing the Fed funds rate.  

In increasing the Fed funds rate, consumers will begin to see their short-term savings vehicles, such as money market funds or certificates of deposit, produce higher yields. There is, however, a problem when inflation is over 8% and short-term interest rates are less than 1%, year-over-year. For cash in the bank or shorter-term investments, purchasing power declines during periods of inflation in excess of earnings, such as now. Put another way, a dollar held in the bank for the past year has not retained its value. Which begs the question, what does one do to combat inflation in the current environment? 

What You Need to Know About I Bonds  

What Are I Bonds 

The U.S. Treasury Department offers individuals the ability to purchase a bond that adjusts its interest payments with the rate of inflation, called Series I Bonds. For the current period of May through October 2022, the rate of interest for a Series I Bond is 9.62%! I Bonds are specifically designed to help retain purchasing power during inflationary periods and are not exposed to the fluctuations in value like other bonds sold on the secondary market.  

Earnings from I Bonds

Series I Savings Bonds pay interest in two parts: a fixed rate of interest set at the time the bond is purchased and a semiannual rate of interest based on the most recent CPI figures (non-seasonally adjusted CPI, or CPI-U). In other words, the bond’s interest payment adjusts based on the actual rate of inflation experienced by the U.S. economy (as justified by the CPI-U index) and those rates are compounded semiannually. Semiannual compounding means the bond’s principal, or the original amount used to purchase the bond, will grow by the most recent composite rate of interest with the next composite interest rate now based off of the new, higher, principal value (original principal + recent composite interest payment). Series I Bonds increase in value during inflationary periods of time and do not adjust below zero in deflationary periods, allowing the investor to protect their cash from inflation without the risk of loss.

How to Invest in I Bonds

I Bonds can be purchased directly through the US Treasury Department with a minimum investment of $25 and a maximum investment of $10k per individual/entity. The holding period is a minimum of one year with a penalty of three months interest when withdrawn before year five. For example, if an investor redeems the bond at the year two mark, they will receive 21 months of interest as opposed to the full 24 months accrued. If an investor redeems their I Bonds after year five, they will not receive a penalty. Investors may hold the bond for a period of up to 30 years. 

There is an option to purchase an additional $5k in I Bonds for a total of $15k for each individual/entity but this additional amount must be purchased through a selection on an income tax return and the bond must be held in paper format, rather than digital.  

I Bond ownership is determined by how the bond is registered. Individuals and in some cases trusts and estates can own I Bonds. For example, a family of four with two dependents can purchase $15k each, or a total of $60k.  

How I Bonds Are Taxed

I Bond income is federally taxable but tax-free at the state level. The semi-annual income payments by the bond are not taxed until the bond is redeemed.  

There is an additional tax benefit should the bond’s proceeds be used to pay for higher education. If the I Bond redemption takes place in a year in which one qualifies for higher education expenses (for themselves, a spouse, or dependent) the redemption will qualify as tax-free at both the state and federal level!

How to Factor I Bonds into a Financial Plan

Mid-Term Savings Goals  

Series I Bonds are a good tool for mid-term savings or money expected to be spent within the upcoming two to seven-year period. For investment horizons longer than five to seven years, stocks are preferred as they have a positive real rate of return after considering the impact of inflation. With I Bonds, their value is retaining purchasing power, not growing it.  

College Planning

Value can also be found when using I Bonds as a component of college savings. Aside from the tax-free distributions when used for qualifying higher-education expenses, I Bonds can reduce portfolio volatility and pace inflation while preparing for college expenses.  

Every financial plan is unique. If you have questions about whether I Bonds are an appropriate solution for your investment portfolio, contact your Certified Financial Planner ™ professional.   

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