What are I-Bonds?
What the heck is an I-Bond and why is everyone talking about them?
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The stock market has been more volatile than usual as of late, and that uncertainty has a lot of people searching for investment opportunities that are a little more...stable?
Aside from the market volatility, inflation is running rampant, the real estate market is showing no signs of cooling and now we have to worry about Monkey Pox too?
You may have heard some of the hype around I-bonds and how they can potentially be a lucrative and low-risk way to protect against inflation over time. Let's take a closer look at what they are and how they work.
What is an I-bond?
Put simply an I-bond is a savings instrument offered by the government that is designed to help people combat inflation.
Bonds are most often offered by governments, but they can also be offered by other entities like a corporation. Bonds function like loans: The bond buyer is the lender, and the organization selling the loan is the borrower.
Because of how bonds function, they are often considered low risk compared to investing in stocks. Bonds are guaranteed by the seller’s willingness and ability to pay instead of on how profitable a company is.
Series I Savings Bonds, or I-Bonds, are a specific type of bond sold by the United States government.
- I-bonds are easy to access: They have a $25 minimum purchase requirement when you buy electronically. Some funds in the stock market have minimum share purchase requirements, which can keep many people out of certain investments.
- I-bonds also compound every six months, which makes them advantageous for long-term financial planning.
- I-bonds issued May-October 2022 will have a 9.62% initial interest rate. The initial interest rate applies to the first six months. This recently announced high interest rate combined with concerns around inflation are fueling current discussion about the financial advantages I-bonds can offer.
How do I-bonds work?
We’ll break down how I-bonds work in three categories:
- Accruing interest
- Purchasing limits
- Cashing I-bonds
I-bonds accrue interest on the first of each month until they reach maturity at 30 years. They also stop accruing interest when you cash them.
Every six months, the accrued interest becomes part of the principal. This process is referred to as compounded interest. It matters because interest is calculated based on the principal.
Here’s an example:
The average I-bond interest rate since 1998 is 10.56%. In this example, we’ll assume a consistent 9% interest rate.
If you buy a $100 I-bond, after the first year, you’ll have earned $9 in interest and it is added to your initial $100 principal amount for a total of $109.
At the five year mark, you’ll have $155. After 10 years, the bond will be worth $241. It’s worth $581 after 20 years. When the bond is fully mature at 30 years, it’s worth $1,402.
Compounded interest is highly beneficial the longer you hold something. This feature of I-bonds makes them an attractive option for long-term financial strategies.
The compounded interest is a key part of an I-bond’s strategic value. The other advantageous part of an I-bond’s interest rate is its association with inflation and deflation.
The I-bonds’ interest rate is a composite of a fixed rate and an inflation rate. The formula is: [fixed rate + (2 x inflation rate) + (fixed rate x inflation rate)].
The fixed rate never changes. The current fixed rate for I-bonds is 0%. The fixed rate has been below 1% since 2008. The highest it’s been since then was 0.7% in November 2008, but it’s typically fallen between 0% and 0.3% since 2008.
The inflation rate changes every six months based on the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U). The new rate is set the first business day of May and November. However, new rates are applied to bonds based on their issue date.
For example, if you bought a bond in October, the new inflation rate would be applied to your bond’s interest on April 1 and October 1.
The inflation rate lowers during periods of deflation and can even be negative. However, the composite interest rate will never go below 0%.
Keep in mind that the interest accrued on I-bonds is subject to the federal income tax. I-bonds are also subject to estate or inheritance taxes.
Next, here are the rules for purchasing I-bonds:
Individuals can purchase up to $10,000 in I-bonds per calendar year and up to an additional $5,000 in paper bonds using your tax return when you file. The $10,000 limit also applies separately to businesses, trusts, and estates. Depending on your situation, you may be able to buy more than $10,000 in I-bonds.
The primary reason you buy a bond is to benefit from the accrued cash value. What follows are the basics on when and how you can cash your bonds.
I-bonds have a mandatory one-year holding period, so you can’t cash the bonds for 12 months after you buy it.
If you cash these bonds during the first five years, you do not receive the interest gained during the last three months.
These bonds also mature over a 30-year period, so they gain value over time. Once they reach 30 years, they’ve reached their full value.
The good news is, even if you’ve forgotten about I-bonds, they don’t expire after 30 years. The bonds’ value stops growing after 30 years, but you can still cash them for their value.
Should I buy I-bonds?
You’ll have to decide how I-bonds fit with your financial plans and investment strategies. Identifying the pros and cons of I-bonds will help as you consider investing in I-bonds.
- Reliable returns: I-bonds compound twice per year and accrue interest at fixed-rates. These rates are also adjusted twice per year to account for inflation or deflation.
- Low-risk investment: I-bonds’ value does not fluctuate like stock investments do. The value accrued over time won’t suddenly drop. However, interest rates can go up and down.
- Some tax exemptions: You’ll only have to pay federal income tax on the interest your I-bonds earn. You can avoid the income tax if you use them to pay for education following guidelines in IRS Publication 970.
- Low liquidity: I-bonds can’t be cashed for one year, and there is a penalty for cashing them during the first five years. I-bonds aren’t a replacement for an emergency fund because of these factors.
- Interest rates may be lower compared to returns on investments: Although I-bonds can have a higher interest rate than savings accounts, they may offer lower rewards than investments in the stock market. I-bonds also may have a 0% interest rate during periods of deflation.
- Long-term investment: I-bonds are designed for long-term benefits. If you’re interested in something for the short-term, you may want to consider other options.
How do I buy I-bonds?
You can buy I-bonds directly from the U.S. Treasury. You’ll set-up an account to use to purchase and store your bonds electronically. If you buy I-bonds with your tax return when you file taxes, you’ll receive paper bonds in the mail.
The minimum purchase for an electronic I-bond is $25. It is $50 for a paper bond.
The U.S. Treasury advises against buying a I-bonds in any way besides directly from the U.S. Treasury. Bond ownership is not transferrable, so all you get is a piece of paper.
The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. This information is provided strictly as a means of education regarding the financial industry.