Investing in I Bonds: An Intro to I Bonds for Young Investors

For an update on I bonds rates as of(10/18/12), please see: November 2012 I bonds rates are announced: 1.76%.  

Series-I-U.S.-Savings-BondsBelieve it or not, the money in your savings and checking accounts is actually losing money.  It doesn’t even matter what bank you have.  Whether you bank online, or brick and mortar; they’re all losing money due to inflation.  Inflation usually won’t appear all of a sudden, but it can systematically eat away at your returns over time.

I’ve seen inflation first hand and I’m sure you have too.  When I was in high school, I would always buy a 20 oz. Powerade or a 20 oz. Sprite at the vending machines for just one dollar.  I can guarantee you won’t find any 20 oz. soft drinks for a buck anymore, instead, now they’re around $1.50.  So a fifty cent increase over 12 years works out to about 4.17% inflation on the cost of a soda!  Now inflation is somewhere closer to 3% per year but you get the point.

Series I bonds were introduced to combat this very phenomenon.  They are actually government savings bonds issued by the US Treasury that offer inflation protection.  Each I bond pays interest based on two components: a fixed rate and an inflation rate.  These two rates make up what’s known as the composite rate(total yield).

The fixed rate is fixed for the life of the given bond and this rate is announced on May 1 and November 1 of each year.  The inflation rate is based on the Consumer Price Index, or CPI.  This rate is also announced every 6 months on May 1 and November 1 and is based on the change in the CPI-U from the previous 6 months.  This inflation adjustment applies to existing I bonds and newly issued ones.

Current Rates

I bonds aren’t doing too hot right now, but new rates will be announced on November 1st.  I’m very curious to see what the rates will be like since there’s been a lot of speculation about a downward trend in the CPI.  The current I bond rate is at 2.2% through October 31, 2012.  The fixed portion is actually paying 0% right now, but the inflation rate is at 2.2%.  Treasury direct provides rates as semi-annual rates so you need to multiply their rate by two to get the yearly rate.

Here’s how the composite rate for I bonds issued May 2012 – October 2012 was set:

Fixed rate = 0.00%
Semiannual inflation rate = 1.10%

Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
Composite rate = [0.0000 + (2 x 0.0110) + (0.0000 x 0.0110)]
Composite rate = [0.0000 + 0.0220 + 0.0000000]
Composite rate = 0.0220
Composite rate = 2.20%

Can You Ever Lose Money With I Bonds?

The best feature about I bonds is the inflation protection that they provide.  In addition, they are one of the only investments in the world that is fully guaranteed by the United States government.  I Bonds can never return less than 0% so in times of severe deflation you’d actually be making money.  And if inflation picks up, you would earn more interest through the increased inflation rate.

Purchase Limit

In any single calendar year, one person may purchase up to $10,000 in I bonds through Treasury Direct’s website, but you may purchase an additional $5,000 using your tax refund.  So a single person could get a maximum of $15,000 while a married couple could get $25,000(filing jointly).

Holding Period 

Series I bonds are meant to be long term investments so one of the drawbacks is the holding period.  Unlike TIPS or other government issued bonds, I bonds cannot be resold on the open market.  You must hold onto an I bond for one year, but after that, there is only a 3 month interest penalty if you redeem your bond.  After 5 years, there is no penalty to redeem an I bond.

Taxes

Interest from I bonds accumulates tax deferred for up to 30 years.  Unlike CD’s which distribute interest monthly(or annually), I bonds distribute interest when they mature or when they are redeemed.  I bonds are exempt from state and local taxes but you will have to pay taxes federally.  One caveat though, if you use the entire proceeds of the I bond(principal and interest) to pay for qualifying educational expenses, the interest can be tax free at the federal level(although there is an AGI phase-out).

Who Should Buy I Bonds?

I Bonds probably don’t make sense for wealthy individuals or big time investors because of the low purchase limits.  But for the rest of us, they are a unique risk-free savings tool.  I currently don’t own any I bonds, but I’ll definitely be taking a look at them once the new rates are announced on November 1st.

10 years ago, I bonds were paying over 6% on the fixed portion alone!  There are probably even still a few people around who locked in that rate and have another 20 years or so of risk free return at 6%.  Although I bonds make more sense in a high interest rate environment, where you can lock in the high rate, there is still some value to holding them now.  2.2% isn’t a ton but it’s more than almost all other banks.

If you do plan on buying I bonds, make sure to do it at the end of the month, since I bonds earn a full month’s interest as long as you own them on the last day of the month.  Conversely, if you plan on selling your I bonds, make sure you do it on the first couple days of the month since holding them until the end of the month won’t gain you any extra interest.

Readers, have you thought about investing in I bonds or do you already own them?  If the rate goes down, I don’t see any point in buying them as my 5 year CD’s at Ally are all around 1.75%.

-Harry @ PF Pro

For an update on I bonds rates as of(10/18/12), please see: November 2012 I bonds rates are announced: 1.6%.  

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Hi, I'm Harry, the owner and head writer for Your PF Pro. I started this site back in 2011 in order to create a place where young professionals could come and get all of their financial questions answered. On the site, you'll find articles on everything from asset allocation for retirement to saving money at Chipotle! So enjoy..

Comments

  1. says

    I have heard of these.and have considered using them to stash my emergency fund but it isn’t a high priority right now. I would have other cash to use if I had to but would replace it by cashing a bond in early even if there is an interest penalty.

    • says

      Yea it’s not a high priority for me either right now, but it’s good to know about your options. There are people who bought I bonds just 10 years ago, who are locked in for another 20 years at 6%!

  2. says

    I’ve never really invested in I Bonds. I know that my stepfather used to buy several hundred dollars worth each month for a number of years. They can be another useful tool for investing. I bet they were better years ago before we had near negative interest rates. :)

    • says

      Yep they were definitely better 10 years ago, but if the rate stays at 2.2%, that’s better than you’ll get anywhere else right now. There’s the one year holding period but after that it’s only 3 months of interest. And after 5 years, there’s no penalty to redeem. You can use a simple laddering strategy if you’re worried about that first year too.

  3. JY says

    I have bought the TIPS mutual funds in the past — these are a great way to diversify inflation protected securities and are more flexible as to when you can sell.
    I am skeptical of the inflation rate used as it always seems to be under-reported. But these are probably better than E bonds at the moment.

    • says

      Yea I agree with you about the inflation rate. I like TIPS too, I actually hold them in my HSA so I don’t have to pay taxes on the investment gains(since HSA’s are taxed in CA).

      The good thing about ibonds though is that if interest rates go up, you can redeem them and buy new ones at the higher rate.

      • JY says

        I’m actually starting to wonder if the E/EE bonds will turn out to be a better investment over the next 20 years. Since they are guaranteed to at least double after 20 years that makes the effective interest rate about 3.5%. This has to increase soon, I wouldn’t be surprised if they increase this to 25 or 30 years in the near future.

  4. says

    The limit is $10k per Social Security Number at TreasuryDirect. They were going to lower it to $5k late last year but they raised it back to $10k in January. The $5k per tax return using tax refunds is extra. So a single person can buy $15k, married $25k if they use the tax refund option.

    • says

      Thanks for commenting Harry. I actually thought about tweeting you this very question, haha But I spent 30 minutes researching the limits and I thought I had it right, I’ve updated the post with the correct limits, thanks again!

      I think 15k is a pretty substantial amount no matter how much money you have :)

  5. says

    I’ve bought I-Bonds for years and hold a portion of my emergency funds in I-Bonds. They are great vehicles. One other big advantage to I-Bonds that most people don’t talk about is the ability to shift tax responsibility if you have multiple bondholders or assign a beneficiary.

    I-Bonds are great financial tools. Unfortunately, few people take advantage of them.

    • says

      Hey JP, I read about that when I was doing some research for this article, it seems like a pretty neat idea. I love learning about things like that, back door roth ira’s, etc

      I bonds aren’t flashy but people who bought them 10 years ago are loving that investment right now!

  6. Bichon Frise says

    I-bonds are great for the emergency account, assuming you have enough cash to get you through a year. My I-bonds were fetching 3.06% and started at 2.2% this month. Much better than a CD right now!

    So, when you buy, you lock in that rate for 6 months regardless of when you buy. When the CPI data comes out on 10/16, we should be able to see what the inflation component will be “CPI-U Sept”/”CPI-U Mar”. You then have roughly 2 weeks to decide if you want to use the current 2.2% rate or wait until Nov to purchase and get in at the new rate. Pigs will fly before the fixed rate is raised this Nov.

    • says

      Wow, that’s good to know, that makes i bonds even better IMO. I don’t think they’ll be going up either, but as long as they stay the same I’ll probably buy some.

      I’m not too worried about that first year, but I agree, I bonds are a good option for an emergency fund.

    • Steve says

      Isn’t it true that the inflation component applies in six month chunks? So even though you can choose to use the current 2.2% rate, in six months you’ll start getting the nov2012 rate for six months, and so forth. Rushing to buy before oct 31 seems like you’re just shifting things around a little bit; in the long run it’s just noise.

  7. Matt says

    I appreciate the work done here and the explanation of these types of investments. So thanks! However, if you think conceptually about these bonds, they’re frightening. The government has a glaring conflict of interest. These bonds are supposed to protect against inflation. Inflation is created by the government. The way that these bonds, both I bonds and TIPS, are adjusted for inflation, as you have said, is that the rate is based on the CPI. CPI is measured, calculated, and reported by the government.

    So, since the government creates inflation, but would rather it appear low, and it pays based on the inflation level that it itself reports, there is a glaring conflict of interest. That’s like having the fox set the security measures for the hen house. The government can make the CPI suggest a lower inflation number than the actual one. In fact, the CPI is constantly being changed, by the government, in order to make inflation seem less than it actually is.

    Also, if you believe that inflation is under 3%, or is under control at all, then I suggest you read Peter Schiff’s book, The Real Crash. He even has a section on why TIPS are a bad idea.

    Finally, with the Fed printing ever more money, and buying more and more toxic assets and securities from incompetent banks, I still believe that your best protection against inflation is in precious metals, and perhaps some farmland.

    Sorry to be harsh and/or cynical, but it seems worth mentioning.

    • says

      Matt, good to see you back! If we were living in communist Russia, I might be a little more worried with buying a government controlled investment like this. But we’re in the good ol’ USA! Obviously, the government can and is printing more money(Q3 quantitative easing or whatever the hell they call it). If inflation rose to 10%, do you think the US would report 2-3%, no way. They’ll lowball it of course but not by more than 10-20% imo.

      I’m not buying these bonds though because I’m worried about inflation, it’s more of a nice benefit. I’m buying them because they give a better rate vs CD’s or any other guaranteed investment. The risk-reward on a 2.2% i bond with a 3 month interest penalty is better than my 5 year CD at ally paying 1.75% with a 2 month interest penalty.

      • Matt says

        Haha. Well I guess you’re more trusting of Uncle Sam than I am. If you read the Constitution, you can see how far we’ve strayed from it. The fact that these are tax-protected investments shouldn’t even be an issue, as the income tax itself is unconstitutional. But I digress.

        Anyway, I think your reasoning is great. And yes, you definitely get a better return on I bonds than CDs or savings accounts. But that’s only because the Fed keeps rates artificially low. So you’re again looking to the government to help you out of a hole that the government dug you into!

        Also, I think bonds of any sort that are payable in US dollars right now are a terrible investment. We continue to devalue the dollar (inflation), now for an indefinite amount of time (QEternity). I think it’s obvious that the dollar is going to collapse, making any bonds in US dollars much less valuable in the future.

        If inflation, based on soda or any other goods, is actually close to 4 or 5% for the past 20 years, why would that rate be going down to 2.2% after the bailouts and the increases in government spending? 10%? Maybe not. But I think 6-7% is much more realistic, and may even be low.

        • Bichon Frise says

          If you haven’t finished off your fallout shelter, get it going and stock it up with 2 years’ worth of supplies. You heard it here first folks, chicken little’s prophecy is coming to fruition!

          The doom and gloom is regurgitated fodder. Perhaps we should try a little “independent thinking?”

          • Matt says

            My shelter doesn’t allow name calling, so you won’t be invited.

            You sound like the people who said that there was no bubble in housing. If you read about the people who predicted the housing bubble (Peter Schiff, Michael Burry, Steve Eisman, etc.), they’re all predicting a fall for the US.

            But you don’t need to just blindly follow these prophets. Once you learn real economics (as opposed to Keynesian), it’s as clear as day. Independent thinking is what brought me to these conclusions. If I listened to economic “experts” I’d be buying a home, taking out student loands, and buying US stocks right now.

            Interest rates will go up. The US will be in serious trouble when that happens.

  8. JT says

    @Matt: I’m fine with most of what you’re saying except I was wondering what you meant by the income tax being unconstitutional. The Sixteenth Amendment seems to have answered that.

    • Matt says

      There’s a long, technical answer to that. Here’s a link to the explanation:

      http://lewrockwell.com/schiff/schiff170.html

      To put it simply and quickly, income has been defined by the SC, after the passage of the 16th amendment, as corporate profits,. Since people aren’t corporations and don’t earn “profits,” the income tax is still unconstitutional, according to the SC. In order for the tax to fall within the confines of the Constitution and of the definition of income as provided by the SC, the tax would either have to be apportioned among the states based on population, or the income would have to be separated from its sources.

      I hope that helps.

  9. Bichon Frise says

    For those of us not busy making an under ground bunker and not clad in tin foil, I-bond rates will be going to 0.86% starting Nov 1. Buy the last week of Oct if you want in on the 2.2% action.

      • says

        Thanks for the info BF. So only a slight decline. What do you think? I mean my Ally CD’s are all paying 1.75% or more right now with only 2 month’s interest penalty.

        Trying to decide whether I should do 5 or 10k, at least I know I can lock in a (2.2 +1.76)/2 = 1.98% return for a year. If it goes below 1.76, might be time to cancel in a year though.

        • Bichon Frise says

          You have to remember, if you do things correctly (buy at end of the month, sell at the beginning), your money will only be tied up for 10 months (but you will be paid for 12 months). You will also have to forgo the last three month’s interest. MY understanding is that the interest is calculated as simple interest for 6 months, then it is capitalized when it changes rates and goes to simple interest for the next 6 months.

          Using that as a basis for calculating the interest on i-bonds (and accounting for the early redemption penalty), I calculated an effective 1.54% APR if you hold for 12 months and an effective 1.84% APR if you hold for 10 months (which may be slightly lower depending on where you park your money for the other 2 months). I think if you can park the money for the “year”, I would go for it. Similarly, Ally’s rates are 1.68% APR, and forgoing the last 2 month’s interest would give you an effective 1.18%. It is all about how they calculate it, and I assumed compounding monthly. With the simple interest from i-bonds, your penalty seems less severe b/c of the “straight line” interest. The compound interest at Ally will give a little more sting b/c you make less at the start and more at the end.

          Then, you have to ask yourself, is the gov’t manipulating inflation numbers for the time being. A year ago exactly, you were looking 4 something %. Another good question is, if i-bond rates continue to fall, does that have an impact on CD rates?

        • says

          BF, you are the man(right?)! haha Thanks for the detailed calculations and breakdown. I calculated 1.84% also if you hold for 10 months. I think I’m going to buy 10k to test things out and see how it goes

          This will be my first i bond purchase but the math seems to make sense, we’ll see how the rates go from here though. I can always cash out later and drop into ally 5 year CD’s if rates go up significantly.

  10. TB says

    Thanks for the info. I bought my first I-Bond with my tax refund, so I appreciate the education behind these type of savings bonds.

    • says

      That’s great, I’m glad I could help. You got in at the right time too since they just announced the new CPI rates and I-bond payouts are going down from 1.76% to 1.18%.

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