I Bonds

I Bonds Explained! (Is 7.12% Guaranteed for Real?)

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Are you looking for a way to fight inflation in your investment portfolio? Inflation rates have been hitting highs not seen since 2007 and purchasing power is a big concern for Americans. Savings accounts and bank CDs are generally yielding somewhere between zero and 0.5% annually, which has also left many wondering where to invest their money. 

The U.S. Department of the Treasury is now paying a 7.12% annual rate on I bonds. Is that for real? In this blog, we are going to explain why several investors are looking into I bonds and we will give you our honest opinion on this investment strategy.

What are I Bonds?

I bonds are savings bonds issued by the federal government. They are designed to protect the value of your money from inflation. The “I” stands for inflation. The interest rate on I bonds is directly correlated with inflation. If inflation is high, the interest rate is high. If inflation is low, the rate is low. Inflation is quite high right now. It hit 6.22% in October which is well above the 1% or 2% inflation that we’ve been used to. 

The Treasury created 30 year I Bonds in 1998 so that investors had a tool they could use to hedge against inflation. They are backed by the federal government, so unless the government shuts down and defaults on its debt (which politicians like to threaten every now and then), the interest rate on I bonds is almost guaranteed. In essence, think of I savings bonds as like a high-yield CD. 

How are I Bonds interest calculated? 

I Bonds interest rate is a combination of two rates which is called the composite interest rate. It is calculated based on a fixed interest rate and an inflation-adjusted rate.  The interest structure is what makes I Bonds quite unique. 

The composite interest rate is a complex formula: Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]

  1. The fixed interest rate is set at purchase and lasts 30 years. This is currently set at 0%.
I Bonds Fixed Rate

2. The inflation adjusted-interest rate is calculated twice a year which is usually May 1 and November 1.

When you go to the Series I Bonds, it will say you’ll get 7.12% interest rate from now until April 2022.

Do I Bonds earn interest monthly? 

Yes, I Bonds earn interest monthly. However, you only get access to those interest payments when you cash out the bonds. The interest you earn is added to the value of the bond twice per year (May and November). 

Is the current inflation interest rate on I Bonds 7.12%? 

Yes, 7.12% is the current inflation interest rate if you purchase the I Bonds before May 1, 2022. The reason the inflation interest rate is so high is because inflation has been quite high for the past months. This also means that the composite rate is also an annualized 7.12% for the first 6 months that the bond is held. This is the highest that it’s been since May 2000. 

For an investment that’s guaranteed by the federal government, that’s very attractive! However, before you go on an I Bonds shopping spree, wait and read the fine print! You must own the bond for at least 5 years to receive all of the interest. You can cash out an I Bond after one year, but if you withdraw it before 5 years, you’ll forfeit 3 months of interest. How does that affect your return?

Two scenarios:

  1. Inflation stays high, and the interest rate of I bonds remains 7.12%. You could cash out after 12 months. However, you’ll only get 9 months’ worth of interest. This means that your net interest rate drops to 5.34%. That’s still not bad. 
  2. Inflation drops to November 2020 levels in May (0.84%).  Your net interest rate drops 3.3%. 

How long do you have to hold an I Bond? 

You can cash I bonds once you have owned them for a minimum of one year. However, if you cash them in before five years, then you will lose three months of interest. I bonds earn interest for 30 years unless you cash them out before then.

Are I bonds taxed?

I bonds are subject to federal income taxes but they are exempt from state and local income taxes. This makes them even more attractive to those who live in high-tax states and cities. They can sometimes be fully tax-exempt if they are used to pay for qualified higher education.

You can choose to pay taxes on the interest earned when the I bonds are cashed. If you cash out any I Bonds in a specific year, then Treasury Direct will generate a 1099 tax form for the accumulated interest. 

The owner is responsible to pay for the taxes. This means that if you were gifted an I Bond, then you are required to pay the tax owed

How many I Bonds can you purchase per year?

You can buy up to $10,000 worth of I bonds annually. You can also purchase an additional $5,000 with your tax refund. This is $5,000 per tax return, not per person. If you are a single tax filer then you can purchase $15,000 annually ($10,000 electronically and $5,000 with your tax refund). 

For those with larger portfolios, the $10,000 annual limit on I Bonds can make them look less appealing as an investment strategy. However, there are some additional ways that you can purchase more I Bonds. If you have a business, then the business can purchase an additional $10,000 in I Bonds per year. If you have a trust, then you can purchase an additional $10,000 for the trust account.

For example, if you are a married couple filing jointly and you each have a business and one has a trust then you can purchase $55,000 in I Bonds as outlined below.

  • $10,000 in Person A’s personal account 
  • $10,000 in Person B’s personal account 
  • $10,000 in Person A’s business account
  • $10,000 in Person B’s business account
  • $10,000 in Person A’s trust account
  • $5,000 using money from their tax refund

Are I bonds a good investment?

I’ll give you 4 reasons why I bonds might be a good investment and 4 reasons why you should think twice.

4 reasons why they might be good investments:

  1. I bonds are a great inflation hedge. Whenever inflation is up then the rate is up.
  2. 3% to 5% potential return for an investment guaranteed by the federal government is pretty good. Think about what you’re earning in cash right now, 0.50% if you use a high yield savings account.
  3. I Bonds are exempt from state and local taxes but you do have to pay federal taxes. They may also be entirely tax-exempt if they are used to pay for qualified higher education. It can be an attractive college savings strategy as an alternative or in addition to a 529 plan.
  4. Their value can never go below zero.

4 caveats you need to know before buying I bonds:

  1. There is a lack of flexibility because you will be locked-in for 1 year. You cannot withdraw for the next 12 months and even if you do withdraw after 12 months (but before 5 years), you will forfeit 3 months worth of interest. 
  2. If inflation drops, then your return will drop. 
  3. The maximum purchase of digital I Bonds is $10,000 per person. You can also use your federal income tax refund to purchase an additional $5,000 in paper I Bonds. You will need to think about if that’s worth your time.
  4. If you have excess cash, can you make more money investing in stocks?

Can I Bonds lose value?

No, I Bonds can’t lose value. The interest rate cannot go below zero and the redemption value of your I bonds can’t decline.

How can you buy I Bonds?

There are two ways to buy I Bonds.
1) You can purchase I Bonds electronically via TreasuryDirect.gov.
2) You can also purchase up to $5,000 of paper I Bonds from your tax return. 

You cannot resell them and you must cash them out directly with the US government. Electronic I Bonds can be redeemed directly on the Treasury Direct website and the paper I Bonds can be cashed in at a local bank. 

To purchase electronic I bonds from the Treasury Direct website, follow the instructions below. 

Step 1: Choose the type of account you are opening.  You will choose the first option for individual/personal. You will also use this option if you are purchasing for a business or a trust.

Step 2: Provide personal information. This includes information such as your SSN, email address, bank account, and routing number. Since the application is linked to a bank account, make sure that you choose one that you are going to use forever. Changing a bank account once you have established an account on Treasury Direct can be a complicated process. 

Step 3: Choose your password, personalized image, security questions etc. After you have completed this step, you will receive your account number by email. Make sure you save your account number because this is what you will use to log in to your account.

Should I invest in I Bonds in 2022? 

The current inflation interest rate of 7.12% makes I Bonds attractive for some investors. That said, the actual rate you’ll likely get will be less than that. If you want a guaranteed investment that will protect your cash from inflation, then you can consider I Bonds. However, they are not right for every investment portfolio. If you have any additional questions about I Bonds, feel free to schedule a complimentary discovery call with one of our fiduciary financial advisors today.

Best Financial Planner Washington DC

Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.

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District Capital is an independent, fee-only financial planning firm. We help professionals and entrepreneurs in their 30s and 40s elevate their finances and maximize their money. We are based in Washington, D.C and we work with people virtually nationwide.

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