I-Bonds
Inflation-Linked Bonds (I-Bonds)
Inflation is top of mind for most consumers today. It erodes your savings as each dollar buys you less of a good or service. By putting your cash in a savings account, CD, or stuffing it under your mattress, you are LOSING money in real terms (adjusted for inflation). The mattress has rarely been this unsafe.
Your savings account is paying you next to nothing, inflation is high, and you are looking for an alternative place to safely stash your money. In come Series I savings bonds, also known as inflation-linked bonds or I-Bonds. These bonds:
Are 30-year bonds issued directly by the Treasury to the public.
Allow you to hedge against inflation without taking market risk.
Are backed by the full faith of the US government.
Are currently paying an annual interest rate of 7.12% for the next six months.
Are sold at face value and the interest rate cannot go below zero.
How Do They Work? The interest rate, or the composite interest rate, is based on a fixed interest rate and an inflation-adjusted rate.
Composite rate = fixed rate + (2 * semi-annual inflation rate) + (fixed rate * semi-annual inflation rate)
Fixed Rate: This is set when you buy the bond and remains for the life of the bond. It is currently 0%.
Inflation-Adjusted Interest Rate: Calculated twice a year, May 1 and November 1.
The interest rate recalculates semi-annually, reflecting the change in the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items including food and energy. Current inflation is higher than in November when the 7.12% interest rate was calculated, suggesting we could see the May 2022 interest rate even higher. The November interest rate uses September data and the May interest rate uses March data. While March data isn’t available yet, if we used February data the rate would be 7.42%.
I-Bonds allow savers to hedge against inflation with the safety of a security backed by the federal government. Unless the government defaults on its debt, the principal is as close to guaranteed as you can get. The principal paid for the I-Bond cannot lose value and the interest rate cannot go below zero. Therefore, the redemption value of the bond cannot decrease.
The interest is compounded semi-annually. What does this mean? Twice a year the interest earned on the bond over the last six months is added to the bonds principal value. The next interest payment for the next six months is calculated using that principal value. You earn interest on your interest!
How Do I Buy Them? The minimum purchase is $25 for electronic bonds and $50 for paper bonds. You can buy them on TreasuryDirect.gov or on your tax return. They are sold directly from the US government. You can even set up a payroll direct deposit. They are redeemed directly on that Treasury Direct website if they are electronic, or if they are paper, you can go to your local bank.
How Much Can I Buy? There is an annual cap currently $10,000 per social security number. An additional annual purchase of $5,000 per tax return is permitted through your federal tax refund. If you have a business, you can purchase an additional $10,000 annually through the business and if you have a trust, the trust account can also purchase an additional $10,000.
What If I Want to Get My Money Out? While these are 30-year bonds, the bonds can be redeemed after a minimum of one year. There is no penalty after the first 5 years. If you cash out before 5 years (but after 1 year) you will give up 3 months of interest. Not too bad!
How are they taxed? I-Bonds are exempt from state and local income taxes, making them even more attractive, especially in a high-tax state like New York. However, the accumulated interest earned is subject to federal income taxes, unless they are used to pay for qualified higher education expenses.
You can either report the interest earned every year or defer reporting until you cash the bond. If you buy I-Bonds in your child’s name you’ll likely want to report the interest each year because the federal income tax rates are likely to be lower now than they will be in the future.
Should I Buy Them? I-Bonds make a lot of sense in an environment like today where savings accounts are paying next to nothing, stocks and bonds are relatively expensive, and inflation is high. It helps protect the purchasing power of your savings. They can be particularly attractive as a compliment to your 529 plan for college savings. However, there is an income cutoff to qualify for the education exclusion.
You need to remain in the I-Bond for at least one year. So, if you don’t have excess savings that you are sure you will not need in the next year, this savings vehicle is not for you. Also, if you rely on interest income from your current bond portfolio, this is not a replacement as you will not get the interest until it is cashed. This should also not be used as a replacement for your retirement account. They most likely don’t make sense for most individuals in the highest income tax brackets.
Each individual has unique circumstances. It makes sense to talk to your financial advisor about whether I-Bonds are right for you. If you don’t have one, feel free to reach out to one of our financial advisors and we will take a look!
If you want to geek out on inflation topics and why we think inflation is likely to remain elevated this year, our resident economist would be equally as excited to talk to you.