I Bonds: What, Where & Why

The stock market’s subpar performance has prompted many investors to seek alternative investments and diversify their portfolios. Lower stock prices usually result in rising bonds, hence their appeal.

But owning bonds provides investors with benefits other than hedging their investment against falling stock prices. I bonds can be an ideal investment to combat inflation and earn interest. Benzinga explains what I bonds are, their features, where investors can buy them and the benefits of owning them.

What Are I Bonds?

A Series I bond is a U.S. savings bond that earns interest and helps protect you from inflation. I bonds are a low-risk, high-yielding investment because they provide a fixed interest rate and a variable inflation rate. The variable interest rate is adjusted semiannually to keep up with rising consumer prices. That protects the value of your cash during inflation.

As an I bond investor, you get the best of both worlds by receiving returns and protection from inflation. You earn monthly interest, which is compounded semiannually. That results in the government applying the interest rate to the new principal value every six months. The government calculates the new principal as the total of the previous principal and the interest earned in the last six months.

Fixed Interest and Inflation Rate

The U.S. Secretary of Treasury determines the fixed interest rate, which applies to I bonds issued in the next six months. The Consumer Price Index (CPI) serves as the basis for determining the rate of I bonds, which is announced in May and November. The growth of the principal’s value and the interest you earn increase your I bond value in two ways.

Maturity

I bonds mature after 30 years. The original maturity period is 20 years, then a 10-year extended maturity follows. The Treasury allows you to cash in the bonds after the first year of purchase. You’re penalized the last three months of interest earned if you cash in the bonds within the first five years of ownership. No interest penalty applies for redemption after the first five years.

Besides being an inflation hedge, I bonds are considered very low-risk investments because the U.S. government backs them, and their redemption value doesn’t decrease. You cannot lose your principal, which is the amount of money you used to buy the I bond. The downside of opting for a low-risk investment such as an I bond is lower returns than the ones potentially earned from high-risk assets.

Taxes

I bonds are exempt from local and state taxes. You can choose to report the annual earnings each year or only when you receive the money for the bond.

One way of not paying tax on the earnings is to use the money to fund qualified higher education. If you received I bonds as a gift, you have to pay the taxes. It’s the owner, not the purchaser, who is responsible for the taxes.

Calculating Interest

The Treasury lists all interest rates issued for bonds either as a table that separates the fixed rate, inflation rate and combined rates or a matrix showing the inflation rate, fixed rate and combined rates together.

It calculates the I bond interest rate using the composite rate, which consists of the fixed rate determined at the purchase price and lasts throughout the duration of the bond ownership, and the inflation rate, which is set every May and November.

The formula for the composite rate:

= Fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)

Where to Buy I Bonds

You can buy I bonds via the U.S Treasury Direct’s website. They are not available from your broker.

You’re allowed to buy up to $10,000 worth of I bonds annually. TreasuryDirect allows investors to buy paper I bonds with their tax refunds up to $5,000 in $50 increments. That increases your allowable annual I bond purchase to $15,000.

You can buy electronic or paper I bonds. The minimum amount for electronic I bonds is $25, and you can buy pennies above that amount. Paper I bonds are sold in denominations of $50, $100, $200, $500 or $1,000.

Why Should You Buy I Bonds?

A well-diversified portfolio has proven to overcome almost any market condition. Adding I bonds to your portfolio may combat economic hardships and offer several other benefits a simple savings account can not offer.

Investment Hedge

Stocks are a popular investment option, but their value usually drops during economic turmoil. To protect your portfolio from decreased stock prices, you can use I bonds as a hedge. I bond prices tend to increase when stock prices drop.

Tax Benefits

Owning I bonds exempts you from paying local and state taxes on them. If you choose to invest the earnings made from I bonds into higher education, you could also be exempt from federal taxes.

Low Risk

The U.S. government backs I bonds, meaning you’re guaranteed of receiving the full payment of the invested principal at maturity. Also, the combination of earning from the fixed and inflation rate means your cash is protected from inflation and the bond’s value grows from two sources.

Considerations Before Buying I Bonds

When thinking about buying I Bonds, it's important to know how they work. I Bonds are offered by the U.S. Treasury and help protect against inflation. They provide a fixed return and an inflation rate that changes every six months. Before investing, buyers should consider several factors. Current interest rates, redemption rules, and personal financial goals are important. It's also crucial to understand the tax implications and the limits on how much you can purchase. By looking at these factors, you can decide if I Bonds fit your financial needs.

Interest Rates and Inflation

I Bonds provide a fixed interest rate along with an inflation rate that changes every six months. It's a good idea to look at the current rates before making a purchase, as they can affect your total return. Remember that I Bonds are created to safeguard against inflation, so it's worth considering current economic conditions to see if they match your investment objectives.

Purchase Limits and Duration

You’re allowed to purchase electronic I Bonds up to $10,000 per person each calendar year, and you can also buy an extra $5,000 in paper bonds with your federal tax refund. Be aware of these limits and remember that you need to hold the bonds for a minimum of one year. If you redeem them before five years, there will be a penalty, so keep your cash flow needs in mind.

Tax Implications

I Bonds aren't subject to state and local taxes, and you can postpone federal taxes until you cash them in. If you're thinking of using the interest for education costs, you could be eligible for extra tax advantages. It's a good idea to evaluate your financial circumstances to make sure the tax framework fits your investment plan.

Should You Buy I Bonds?

Buying I Bonds requires careful consideration. Assess your financial situation and investment goals first. I Bonds are a safe investment option backed by the U.S. government. They help protect against inflation. Bonds offer a fixed interest rate and an inflation-adjusted rate that changes every six months. This makes them appealing during rising prices.Before investing, evaluate your financial goals and risk tolerance. If you seek a stable, low-risk investment, I Bonds may be suitable. However, if you need quick access to funds or high returns, look at other options. Be aware of the annual purchase limits: $10,000 for electronic bonds and $5,000 for paper bonds.Consider the tax implications as well. Bond interest is exempt from state and local taxes but is subject to federal tax. You can defer this tax until redemption. This deferral can be advantageous for educational expenses due to potential tax exclusions.Finally, think about how I Bonds fit into your overall investment strategy. Carefully evaluate your financial needs and market conditions. If necessary, consult a financial advisor for tailored advice. By considering these factors, you can make informed choices that align with your long-term goals.

Frequently Asked Questions