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what are i bonds

What Are I Bonds and How Do They Work?

In this article, we will explain what are US Government-issued Series I Savings Bonds and how do they work? Series I Savings Bonds are inflation-protected savings bonds issued by the US Government. They are also known more commonly as I Bonds

I Bonds have been a potential savings asset class for nearly 25 years. They were first issued in 1998 to allow Americans to save money with inflation protection. I Bonds have a feature where part of their total interest rate is indexed to inflation. The variable interest rate is based upon the Consumer Price Index (CPI), so the variable rate goes up when prices rise. 

For savers, this feature is attractive because savings are protected against inflation. In addition, I Bonds can be used as a low-risk short-term investment with some caveats. However, the pros of I Bonds outweigh the cons, increasing their appeal, especially when inflation is high.

what are i bonds
What Are I Bonds and How Do They Work?

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What Are I Bonds and How Do They Work?

To understand this asset class, investors need to know what are I Bonds and how do they work? One crucial consideration is buying I Bonds, which is not straightforward. Next, the interest rates on I Bonds are not so simple for beginners, but it is easily explained. Below we discuss both topics.

How to Buy I Bonds

I Bonds may be bought by two methods: electronically or paper. Electronic I Bonds can be bought directly from the US Treasury. A purchaser requires a Social Security Number or Taxpayer Identification Number (TIN) to open an account. In addition, the paper I Bonds can be purchased with an American’s federal tax refund. 

Minimum and Maximum Purchase

A person pays the face value of an I Bond. The minimum purchase is $25 for the electronic I Bonds and $50 for the paper I Bonds. Electronic I Bonds come in any dollar amount, and it is possible to buy an I Bond for $25.23. Paper I Bonds are available only in $50, $100, $200, $500, and $1,000 denominations.

The maximum annual investment amount is $10,000 for electronic I Bonds and $5,000 for the paper I Bonds. The limits are distinct per Social Security Number or the first person listed on the bond. Hence, a saver can buy up to $15,000 of I Bonds annually.

A husband and wife could theoretically buy up to $30,000 of I Bonds annually, assuming they file their taxes separately. A single filer can purchase up to $15,000 of I Bonds, while a married couple filing jointly can acquire up to $25,000 of I Bonds.

I Bonds can be bought as a gift for others, but this counts towards the limit of the person receiving the gift. The exception is if a person inherits I Bonds.

How Do I Bond Interest Rates Work?

I Bonds have two parts for their interest rate: the fixed rate and the inflation rate. They are added together to determine the composite rate. Therefore, investors must understand the concept of how I Bonds’ interest rates work to calculate their return.

The fixed rate is set when an investor buys the I Bonds and does not change during the bond’s 30-year life. The fixed-rate is announced every six months on the 1st business days of May and November each year by the US Treasury. The fixed rate is valid for all I Bonds issued in the next six months.

The inflation rate changes every six months, the 1st business days of May and November, and is set by the US Treasury. The rate is based on the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, which includes volatile food and energy prices. The inflation rate is for the next six months for all bonds issued.

The history of fixed and inflation rates for the past decade is given in the table below. Also, check the US Treasury website for earlier years.

I Bonds Rates

The date the inflation rate changes depending on when the I Bond was issued, and thus, the inflation rate may not change on May 1st or November 1st for your savings bonds.

I Bonds Rate Change Dates

The composite interest rate is at least 0%, but the fixed rate may be zero, as it has often been since late 2010. The fixed rate has ranged between 0% and 3.6% since 1998. The inflation rate can be negative because of deflation, offsetting a positive fixed rate, and thus the composite rate can be lower than the fixed rate. The inflation rate has ranged from (-2.78%) during the sub-prime mortgage crisis to a high of 4.81% today.

Currently, the annual composite rate is between 6.89% for bonds bought when the fixed rate was 0%, and 10%+ for bonds bought when the fixed rate was 3.6%. Imagine getting more than 10% on a savings account. The US Treasury site has a table of composite rates sorted by when a saver bought the I bond.

Example of I Bond Composite Rate

The most recent rate announcement was on November 1st, 2022.

I Bonds Composite Rates

The interest is compounded semi-annually. The interest is paid and added to the principal every six months from the issue date. Subsequently, the new inflation and composite rate take effect. Interest is earned on the updated principal amount. The maturity for I Bonds is 30 years, and thus they will pay interest for 30 years.

Advantages of I Bonds

Once a saver knows how to purchase I Bonds and understands the composite interest rates, they know a good part of what I Bonds are and how they work. Next, I Bonds have several inflation and tax advantages.

The attractive part about I Bonds is that they are guaranteed by the US Government and are thus viewed as no-risk investments. Of course, no investment is completely risk-free. But the US Government has never missed paying interest on its savings bonds and returning the principal.

As mentioned above, I Bonds are inflation-protected. However, if inflation rises further, the inflation rate resets higher. Consequently, if inflation reaches double-digits, as some people fear in 2022, the interest rate earned on I Bonds will be double-digit, too, depending on the fixed rate. 

Moreover, due to the inflation rate, I Bonds will usually have a greater interest rate compared to high-yield savings accounts, money market deposit accounts (MMDAs), or certificates of deposit (CDs). Therefore, since inflation was high in 2021 and even higher in 2022, many savers are buying I Bonds.

Another significant advantage is the interest earned on I Bonds is tax-deferred at the federal level until they are redeemed. Furthermore, if a saver utilizes I Bonds for educational purposes, the tax on interest is waived by the US Government. However, this benefit has income limitations.

The sweetener is that interest earned from I Bonds is not taxable by states or municipalities. The combination of inflation protection and tax benefits make I Bonds an excellent investment for those in higher tax locales.

Disadvantages of I Bonds

However, to fully understand what I Bonds are and how do they work, investors must know the disadvantages too.

I Bonds are often considered a short-term savings account, but that is not entirely accurate. I Bonds are more accurately a long-term personal bond but can be used for shorter terms assuming an investor is aware of and accepts the penalties.

Next, I Bonds are illiquid for the first 12 months. The minimum holding period is one year before the US Treasury permits redemption but with a penalty. Consequently, I Bonds are appropriate for longer-term holdings and not for a short-term emergency fund.

An investor owning I Bonds for more than one year but less than five years pays a 3-month interest penalty. They lose the last three months’ interest when the I Bonds are redeemed. An investor holding I Bonds for more than five years pays no penalty. 

I Bonds’ interest rate is more complex to understand than high-yield savings accounts or CDs. In both cases the interest is fixed until renewal and an investor can simply calculate the compound interest rate. However, I Bond interest rates fluctuate depending on inflation and are set every six months. Investors must use the Treasury Direct website to determine the value of their I Bonds.

The inflation rate may be set at 0% or even negative, like on May 1st, 2009, and May 1st, 2015. Hence, an I Bond’s inflation rate may be lower than the fixed rate implying the composite rate is less than the fixed rate. However, even if the inflation rate is negative and the fixed rate is zero, your I Bonds do not lose money since the US Treasury does not lower the composite rate to below zero.

Another disadvantage is the US Treasury does not mail a 1099-INT to owners. Hence, a saver must keep track of the amount of interest earned. The interest is deferred but taxable on federal taxes.

Lastly, estate planning may be more difficult for owners of I Bonds because they are often held for decades before redemption. Hence, they are not often included on tax returns, making it difficult for heirs and executors to track the savings bonds.


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Final Thoughts

I Bonds are an attractive way to park cash for at least twelve months, preferably longer. Hence, they can be used to save for large purchases, like a home. Additionally, the tax waiver feature for education makes them attractive to families with children attending colleges. Investors can also potentially use I Bonds instead of Certificates of Deposit (CDs) for longer-term savings.

Importantly, they are risk-free because the US government guarantees them. Next, investors’ cash is protected from loss of buying power due to the variable inflation rate. In essence, I Bonds are a hedge against inflation. This benefit is clearly demonstrated in 2022, the highest period of inflation in about 40 years.

Investors must remember that I Bonds cannot be redeemed for 12 months and have a 3-month interest penalty until the five year mark. However, the few disadvantages are minor relative to the advantages, and investors should seriously consider owning I Bonds as part of their asset allocation.

Thanks for reading What Are I Bonds and how Do They Work?

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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.

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