By Barbara O’Neill, Ph.D., CFP®, firstname.lastname@example.org
Personal Financial Managers (PFMs) often get questions from service members about where to earn the highest interest rates on savings. One attractive alternative that has been called “hiding in plain sight” and “the best-kept secret in America” is the U.S. Treasury Department’s I bond. I bonds rarely receive the media attention of high-flying stocks, and commission-based advisors have no incentive to market them.
I bonds protect savings from inflation for up to 30 years and currently pay 3.54% (until November 1, 2021), which is 177 times the 0.02% average return on money market funds. First introduced in 1998, they are sold at face value (e.g., $50 for a $50 I bond) and earnings are exempt from state and local taxes.
Below are eight key talking points about I bonds for PFM staff to share with military families:
- Interest Rate Formula The earnings rate of I Bonds is a combination of two separate rates: a fixed rate of return (0% since November 1, 2010), which remains the same throughout the life of an I bond, and a variable semi-annually adjusted inflation rate. The inflation rate is determined by the consumer price index for urban areas (CPI-U). The yield on I bonds can never be less than zero in the event of deflation.
- Semi-Annual Interest Rate Adjustments Each May and November, on the first business day of these months, the U.S. Treasury Department announces a composite rate of return that applies to all I Bonds issued during the six month period beginning with the effective date of the announcement. The composite rate is calculated with a formula that incorporates the fixed rate and the six-month inflation rate.
- Investor Interest Rate Adjustments Twice a year- on the anniversary and semi-annual anniversary of a bond’s issue date- an investor’s I Bond will adjust for inflation. For example, let’s say you buy an I bond in October. Your I bond will grow at the earnings rate announced during the previous May. Six months later, in April, the I Bond will pick up the earnings rate announced in the previous November.
- Denominations for Sale A single owner can buy from $25 up to $10,000 worth of I bonds per calendar year electronically via Treasury Direct and up to $5,000 of paper bonds with a federal income tax refund. Paper I bonds are sold in denominations of $50, $100, $200, $500, and $1,000. I bonds, like all federal securities, are backed by the “full faith and credit of the U.S. government” (i.e., the government’s unconditional guarantee to somehow raise money to repay its debt; e.g., via taxes and borrowing).
- Taxation of I Bond Earnings Federal income tax is due on the earnings from I bonds. I bond interest is earned every month and compounded semi-annually. I bond earnings can be deferred until the bonds are cashed in or they stop earning interest after 30 years. Federal income taxes on I bond interest may be excluded from federal taxation if the money is used for qualified higher education
- Liquidity Constraints I bonds are not intended to be traded frequently in response to changes in market interest rates. Rather, they appropriate for five to 30-year financial goals. Investors cannot cash out I bonds until they have held them for 12 months. In addition, if I bonds are cashed in within five years of purchase, they are subject to a 3-month interest loss penalty.
- Peace of Mind I bonds provide peace of mind about the impact of inflation on the value of savings. In the rare event that the CPI-U goes down so the decline is greater than the fixed rate, I Bonds will not decrease in value. Instead, the value of the bond will be maintained until the earnings rate again produces an increase in value. Thus, I Bonds protect investors’ purchasing power from deflation as well as inflation.
- Portfolio Diversification Inflation-indexed I bonds are a good compliment to stocks or growth mutual funds in an investor’s portfolio. They reduce portfolio volatility while providing an inflation hedge. They are also available in a variety of denominations to fit different investor budgets.
For additional information about characteristics of I bonds, review this page on the Treasury Direct web site.