Investing is typically a game of balancing risk and reward. Those who take more risk have the opportunity for higher reward, and those who take little risk are limited to minimal returns. However, there are occasionally times when the relationship between risk and return breaks down, and investors can achieve great returns without exposing themselves to significant risk. United States Series I Savings Bonds are a current opportunity that fall into this category.
What Are I Bonds?
Series I Savings Bonds (i.e. I Bonds or Inflation Bonds) are savings bonds issued by the U.S. Government. Most people are familiar with the standard Series EE Savings Bonds that their grandparents or parents may have purchased for them at birth or as a gift. Lesser known are the Series I Savings Bonds which are currently accruing interest at a 9.62% rate.
I Bonds are purchased directly through the TreasuryDirect website, and they are protected by the full faith and credit of the U.S. government (i.e. considered a risk-free investment).
How Is the Interest Rate Determined for I Bonds?
I Bonds accrue interest based on the combination of a fixed interest rate and an inflation rate. The fixed rate is known at the time the I Bonds are issued and stays the same for the life of the bond. The inflation rate, on the other hand, is updated every six months.
As a result, the total rate of return for I Bonds over any six-month period fluctuates based on the current inflation rate. At the end of each six-month period, the inflation rate is updated and the new composite rate is applied to the next six-month period. The following table shows the composite rates for newly issued I Bonds over time.
Over the last 10 years, inflation has been low which has kept the annual returns on I Bonds in the range of 2% or less. However, the significant increase in inflation during the last year has made I Bonds an attractive option. Currently, I Bonds issued before November 1st, 2022 are yielding 9.62% (annualized).
Since the inflation rate associated with I Bonds is adjusted every six months, investors are not guaranteed to receive the initial rate (currently 9.62%) for more than the first six months. However, given the current environment, it appears that inflation is here to stay at least for the near future which means I Bond returns are likely to remain attractive long enough to be worth considering as an investment.
Key Takeaway:
The interest rate on I Bonds is currently 9.62% for I Bonds issued before November 1st, 2022. The interest rate will be adjusted every six months thereafter.
Are There Purchase Limits?
The primary downside to I Bonds is that there are annual purchase limits which restrict purchases to $10,000 per person or entity in a calendar year with the option of purchasing an additional $5,000 in paper I Bonds using a tax return refund.
Given the annual $10,000 limit per person, I Bond purchases are a great way to obtain a high return on excess cash or a potential option to replace a maturing CD that would otherwise renew at a very low rate. However the purchase limits restrict the ability to use I Bonds for large portions of most portfolios.
While these purchase limits are fairly restrictive, there are ways to increase overall exposure. For example, since the limit is per person each calendar year, an individual could invest $10,000 at the end of one year and then invest another $10,000 at the beginning of the next year.
Another way to gain additional exposure is to make contributions for a spouse and children. Since each person has a $10,000 limit, a married couple can invest a combined total of $20,000 annually. Minor children have their own $10,000 limit; so parents can make a $10,000 annual contribution for each of their children.
Before contributing for a minor, it is important to consider that contributions on their behalf are considered completed gifts. Parents should consider whether they are comfortable transferring funds into their child’s name since those funds will become available to the child when they become an adult.
Another option for individuals who have a business or trust is to purchase I Bonds within those entities. Businesses and trusts are given a separate contribution limit of $10,000 each.
Key Takeaway:
The purchase limit for I Bonds is $10,000 per year. This limit applies annually on an individual basis; so contributing for others and over multiple years allows for greater accumulation.
I Bond Gifting Strategy:
If individuals are interested in a more complex strategy to work around the annual purchase limits, they can choose to purchase I Bonds as gifts. I Bonds purchased as gifts do not count against the purchaser’s annual limit. I Bonds only count against the limit of the individual who receives the I Bond as a gift in the year that they are delivered.
Accordingly, a husband and wife could purchase $10,000 of I Bonds in each of their own names in the current year. In the same year they could also purchase $10,000 of I Bonds as a gift for each other. Since they both already used their own limits in the current year, they would not be able to deliver the I Bonds purchased as gifts until the next year.
Nevertheless, on the date they purchase the gift I Bonds, the holding period begins and interest starts accruing. Then the following year, they can deliver the gifted I Bonds to each other. This allows for additional exposure to current interest rates while complying with the annual $10,000 purchase limits.
The key is that the $10,000 contribution limit still impacts how much can be delivered per year in the future. Accordingly, purchasing substantial amounts as gifts for a single individual would take multiple years to fully deliver. If interest rates go down in the meantime, the ungifted portion would be left earning a lower return until they can be delivered and cashed out. As a result, it is likely not worth purchasing more than one year’s worth of gifts at a time.
Key Takeaway:
Despite the purchasing threshold, there are ways to increase exposure to I Bonds for those who are interested in putting in some additional effort. For others who want to keep it simple, purchasing $10,000 per calendar year can be completed with minimal effort.
Holding Period Requirement:
I Bond holding period requirements fall into one of three categories:
- Less Than One Year: I Bonds cannot be cashed in during the first year after purchase.
- One Year to Five Years: If I Bonds are cashed in between years one through five, there is a penalty equal to the most recent three months of interest. In other words, a bond cashed in after 15 months would receive only 12 months of interest.
- Five or More Years: I Bonds held longer than five years can be cashed out at any time without penalty.
Given I Bonds cannot be sold within one year, it is not prudent to purchase I Bonds with funds that may be needed within the next year. However, if the funds can remain invested for at least a year, I Bonds are very attractive because the rate of return over a 12-month period, even after giving up three months interest for cashing in early, is likely to substantially outperform any return in a bank account or similar fixed income investment.
Interest Rate Adjustment Risk:
Since I Bonds must be held at least one year and the interest rate resets every six months, a big question for many buyers is what the interest rate will be when it adjusts six months after the I Bonds are purchased.
Before diving into that question, it is important to clarify a nuance regarding when the six month inflation rate adjustments applicable to each I Bond take effect.
I Bond inflation rate adjustments are published on May 1st and November 1st each year. However, the updated rates do not apply to all I Bonds at that time. Rather, I Bonds purchased between May 1st and November 1st will receive the May 1st inflation rate for the first six months as long as the I Bond is purchased prior to November 1st (i.e. even if the bond was purchased at the end of October).
Then once the I Bond reaches its six month anniversary, the inflation rate published on November 1st will kick in for the following six months.
In other words, the rates published on May 1st and November 1st control the rate at which the inflation adjustment will reset for any bonds sold or reaching a six-month anniversary during the following six months, but they do not take effect immediately for every bond on the date they are published. The following table from Treasurydirect.gov clarifies when the rates take effect based on the purchase date of the I Bond.
Now that it is clear when the new inflation adjustments apply to each I Bond, it’s time to consider how to reduce the interest rate risk caused by the one year holding period. This can be accomplished by ensuring that the inflation adjustment for the second six-month holding period will be satisfactory before purchasing the I Bond.
I Bond inflation adjustments are calculated by using the change in the Consumer Price Index for All Urban Consumers (CPI-U) over the previous six months. Given the CPI-U data is published in the middle of each month, it will be possible to calculate the November 1st, 2022 inflation adjustment in mid-October.
The method for calculating the updated inflation adjustment is by dividing the most recent monthly CPI-U number by the CPI-U number from six months prior. In the case of the November 1st, 2022 update that will be the October 2022 data divided by the March 2022 data. While we don’t have the October 2022 data yet, we can perform the same calculation using the most recent data through July 2022 as shown below.
Since the example above only uses the data through July, the actual adjustment will vary depending on the actual October data. However, the actual adjustment can easily be calculated at that time by following the same methodology. Given the fixed rate component is currently zero, the composite rate will be equal to the annualized inflation adjustment.
Using the estimated 6.1% inflation adjustment above, it is possible to calculate what the expected return will be over a one year holding period before committing to purchasing an I Bond because the current composite rate is known (i.e. 9.62% which applies for the first six months) and the new composite rate that will be applied to the following six months can be accurately estimated (i.e. 6.1% in our example). The calculation of the expected return is shown in the table below.
As the table shows, the one year expected rate of return for I Bonds purchased prior to November 1st, 2022 is still 6.41% even after forfeiting three months of interest for cashing the I Bonds in prior to the five-year mark. This represents a great return on cash that would otherwise be sitting in a bank account.
Key Takeaway:
Current I Bond returns are still attractive even after factoring in the penalty for cashing the bonds in before the end of five years.
Tax Implications:
For federal tax purposes, I Bonds generate interest which is taxable as ordinary income. Individuals have the ability to choose whether to report the interest annually as it accrues or wait until they cash the bond in and report all the income at that time. At the state level, I Bond interest is exempt from income tax.
I Bond interest can also be exempt from federal tax if the proceeds from the eligible savings bonds are used for qualifying educational expenses. To qualify for this exemption, an individual must meet specific criteria.
The two most notable criteria are that the individual taking the exclusion must have issued the bond in their own name and been at least age 24 when the bond was issued (i.e. bonds purchased in the names of children do not qualify) and that the available exclusion phases out for those at higher income levels. The exclusion is fully phased out at modified adjusted gross income of $154,800 for married couples filing a joint return and $98,200 for single individuals.
Even without qualifying for the education exclusion, I Bonds present some tax advantages. Since the tax can be deferred until the bonds are cashed in, they present tax planning flexibility allowing individuals to choose the timing for income recognition. Accordingly, individuals can choose to wait until a year when they otherwise have less income and can cash in the I Bonds then to maximize the benefit of lower tax brackets.
How to Buy I Bonds:
I Bonds must be purchased directly from the US Treasury at Treasurydirect.gov. We would love to purchase them for our clients, but unfortunately that is not an option. So, the next best option is to tell you how to directly purchase them on your own.
The first step is to go to Treasurydirect.gov and open an account for each individual or entity that would like to make a purchase (minor accounts are opened as a linked account under the parent’s TreasuryDirect login). Bank account information is also required when the account is opened.
Once you’ve created your account, you will be able to purchase I Bonds by selecting the “Buy Direct” tab at the top of the screen. The system will provide an option for which bonds to purchase; so it is important to ensure Series I Savings Bonds are selected. Once the bonds are selected, you can select the purchase amount and schedule the date of purchase. Once you complete your purchase, the bonds will be added to your online TreasuryDirect account.
The TreasuryDirect website includes short, helpful instructional videos providing step by step instructions for those who would like to learn more.
After you’ve purchased your I Bonds, it is important to ensure that you keep a record of them with your estate planning documentation so that your personal representative is aware of the I Bonds in your TreasuryDirect account.
Key Takeaway:
I Bonds can only be purchased directly by individuals through TreasuryDirect.gov. Advisors cannot buy I Bonds on behalf of their clients.
Conclusion
While earning higher returns often requires taking additional risk, I Bonds currently present an opportunity to earn an attractive return backed by the full faith and credit of the U.S. Government.
Whether you are an individual with excess cash looking for a safe investment with a great return, someone who needs cash for a specific purchase at least a year in the future, parents looking to start gifting and saving for their children, or simply an individual who would like to make some extra money, I Bonds are worth considering.
While I Bonds present some very attractive features, their downsides include annual purchase limits and holding period restrictions.
Although we would love to purchase I Bonds for our clients, we cannot. I Bonds must be purchased directly from TreasuryDirect.gov. Accordingly, the next best option is to tell you about them so that you can purchase them yourself. Our goal as Family CFO for our clients is to see them succeed and flourish financially. I Bonds currently are a tool that can help that happen.
If you are interested in working with a Family CFO that can help guide your family’s financial decisions and will provide advice designed to put your interests ahead of their own, we would love to connect to see if what we do is right for you.
