There is a lot of chatter in the financial planning community as well as the investing writers and bloggers about investing in I Bonds. Are I bonds really a good investment right now? As with almost all investing and savings ideas, the answer is that it depends on your current financial situation and what you want to get out of your I bond investment.
What Are I Bonds?
The one thing the finance pundits are getting right is the description of I bonds. I bonds are a savings bond from the United States government just like the more well-known Series EE savings bonds. The main difference is that I bonds are designed not as a basic savings vehicle, but rather as one that keeps up with inflation.
What Is The Point of I bonds?
Technically, if your savings are not keeping up with inflation you are purchasing power. This is not the same as losing money, no matter what anyone tells you. If you have $10,000 in savings earning 1%, you are not losing money. Your savings are increasing at the rate of 1% every year. However, if inflation is 2%, you are losing purchasing power. Statistically speaking, your savings would buy 1% less that it could have each year.
To prevent this loss of purchasing power to inflation, the government offers Series I bonds. I bonds pay interest in two parts. The first part is a fixed interest rate that you earn for the life of the bond. The second part is a variable part tied to inflation. It’s this second part that is making I bonds the star investing vehicle of the moment.
How Much Interest Do I Bonds Pay?
Okay. This is the good part. The current annual variable (inflation) rate on I bonds is 9.62%. Don’t worry, you didn’t miss out. The rate only changes every six months in May and October, and every bond issued during that six-month period gets the current interest rate for the full six months. After six months your interest rate would change to whatever the rate changes to in May.
The fixed interest rate for I bonds is currently 0.0%. Remember, the fixed interest rate on I bonds never changes, so even if the Treasury changes the May fixed interest rate to 0.5% plus the variable rate, you do not get, and never will get the increased fixed interest rate.
What is the Catch to I Bonds?
If this is the question you are asking, you have found your financial independence advice home. Welcome.
It turns out that there are several gotchas to investing in I bonds. None are bad, per se, but going in with open eyes is always the best strategy.
The first catch to I bonds is that inflation is not usually this high. In fact, the reason inflation and I bonds are making so many headlines is because inflation is crazy right now. Although, you have to remember that this comes on the back of two years of basically zero inflation, so it’s more of a snap back than it is necessarily a long-term condition. In fact, I bonds have historically paid much lower interest rates, better than a basic savings account, but maybe less than a high-interest online savings account.
Before 2021, I Bonds paid between 0.0% (May 2015) and 2.76% for the past 10 years. – This isn’t a growth investment. It is a savings investment that is currently experiencing an unusual event.
The second catch to I bonds is you can only buy up to $10,000 worth each year. There are ways to boost this number, such as you and a spouse each buying $10,000, giving you a household investment of $20,000.
The third catch to I bonds is that you are not allowed to cash them within 12 months. So, this makes I bonds a terrible investment for short-term savings purposes.
The final catch is that if you redeem I bonds before 5 years, you will forfeit 3-months’ worth of interest. With rates as high as they currently are, that might not bother you, but be sure to do the math.
Should I Invest in I Bonds?
If you have $10,000 just parked in a savings account that is
- Not part of your reserve/emergency fund
- That you do not plan to need for at least 12 months, and maybe up to 5 years
- That you are willing to accept a varying interest rate
- That you would not be better off investing somewhere else
Then, investing in I bonds is an option for you.
Will I Bonds Pay This High Interest Forever?
Nope. That’s the whole point.
The purpose of I bonds is to protect your money from inflation not for capital appreciation or principal growth. It may seem like you are making money, but statistically, you are just treading water with inflation.
If inflation goes down to one percent next year, your interest rate goes down to one percent (Remember, the current fixed rate is 0.0%)
Can I Get Paper I Bonds?
There is some confusion about getting paper I bonds. Some people just like to have a piece of paper. It can also be nice to be able to hand your grandkids a piece of paper that shows they have a $1,000 investment, rather than just telling them and sending them a link on their iPad.
Unfortunately, you cannot buy paper I bonds directly. You can get paper I bonds only by getting them with your tax refund when you file your tax returns. File Form 8888. You must get I bonds in $50 increments so any extra will be directed to your linked account, or paid as a check. You can name up to two people other than yourself as owners of the paper I bonds you purchase. Note that you can only buy $5,000 of I bonds with your tax return like this.
I Bonds and Taxes
I bonds are state and local tax-free. However, you are required to pay federal income taxes on I bond interest. You can pay taxes on I bond’s interest either by reporting the interest every year, or by just reporting all of the interest when you redeem the I bonds. Most people just report it all at once when the bonds are redeemed, but there may be cases where reporting the interest as you go makes sense.
When bonds held in a Treasury Direct account reach maturity, they are automatically redeemed, and the interest is reported on a 1099-INT Form to the taxpayer and the IRS. Interest from I bonds gets reported with other interest income on Schedule B – Form 1040.
You can however use I bonds tax free for education expenses if you qualify.
Using I Bonds for Education Expenses
The good news is that you can exclude the interest earned on I bonds if you use the proceeds to pay for qualified education expenses. The owner of the bond may exclude interest for educational purposes for the usual list of people including, self, spouse, children, and other qualifying dependents. To qualify, the bonds must be cashed in the same year as the expenses being paid.
As always, your money is a pool of fungible dollars, so whether you use the proceeds to pay for education expenses or not all comes down to you saying that you are using them for education expenses and then documenting the expenses on Form 8815.
Thus, if you redeem $10,000 worth of I Bonds in 2023 and your child is attending Harvard, then you can pay any of their qualified 2023 educational expenses, like tuition tax free. You cannot cross years, so if you cash savings bonds in December of 2022, you cannot use them to pay expenses incurred, or billed in 2023.