Not only does the I Bond offer a measure of protection from the eroding effects of inflation, but it also provides a potentially tax-free way to save for college. Here are some of the details.
I Bonds are sold a face value through financial institutions and directly from the U.S. Treasury in denominations ranging from $50 to $10,000.
How to Buy I Bonds
You can buy up to $30,000 in paper I Bonds per year. In addition, you can purchase up to $30,000 in electronic I Bonds through Treasury Direct.I Bonds have a two-part interest rate. The first is a fixed rate that is set when you buy the bond. The second rate is variable and tied to the Consumer Price Index for Urban consumers. This rate changes twice a year according to changes in the CPI-U.
You can hold I Bonds up to 30 years, however there are penalties for cashing them in early. You can cash them in after 12 months, but if you redeem them in the first five years, it will cost you three-months worth of interest.
Interest is credited monthly and compounded semiannually, however you don’t receive any interest payments until you redeem the bond.
Tax Exempt
I Bonds are exempt from state and local taxes. You don’t owe any federal income taxes until you redeem the bond.If you use the I Bond to fund eligible college expenses, the interest income is exempt from federal income taxes.
I Bonds are safe because they are backed by the full faith and credit of the U.S. Government, which means your principal is guaranteed.
What Happens in Deflation?
If we should enter a deflationary environment, the variable interest rate would be negative so your bond would not increase in value.However, the I Bond would never fall below its face value regardless of the rate of deflation.
Are I Bonds for Everyone?
I Bonds work best in taxable accounts for investors looking for alternative savings vehicles.There are other ways to protect against inflation (stocks, for example), however this is one of the few guaranteed savings instruments that is inflation protected and doesn’t generate a current tax liability.
High-income investors should note that I Bonds might not be your best choice in periods of high inflation. If the fixed portion of the interest payment is not enough to pay the taxes due, you could lose some of the inflation protection aspect of the bond. For example:
If you owned an I Bond with a fixed interest rate of 2.5% and a CPI-U adjusted rate of 6%, your income would be $850 ($10,000 x 0.085 = $850) and taxes about $300 ($850 x 0.35 = $297.50), giving you after-tax income of $550.
However, to keep up with inflation you needed to net $600 ($10,000 x 0.06 = $600). The fixed interest portion of the I Bond was not high enough to cover the taxes owed, so you lost part of the inflation protection.
