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Jul 18, 2023

What are I Bonds?

By Team Stash
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What are I bonds?

I bonds, also called Series I savings bonds, are a type of savings bond offered by the U.S. Department of the Treasury. Investors looking to offset the impact of inflation on their portfolio and reduce risk often consider investing in I bonds because of their relative safety and combined interest rate, which moves with inflation.

Unlike stocks, which generate returns based on increases in share price, bonds earn money through interest. Thanks to their higher interest rates in periods of inflation and potential income tax benefits, I bonds can be an attractive investment. But they also come with limitations to consider before investing.

In this article, we’ll cover:

How do I bonds work

When buying an I bond, investors are essentially loaning the government money, which will be paid back with interest. As long as you hold the bond for at least five years, you can cash it out and receive your principal and all the interest you’ve earned. If you cash out sooner than that, you’ll lose out on some interest. 

These bonds are considered a relatively safe investment because they are fully backed by the U.S. government. As long as the government doesn’t default on its debt, which it has never done, I bonds are considered a safe option for earning inflation-adjusted, tax-deferred interest. 

How to buy I bonds

I bonds can only be purchased through the U.S. Department of the Treasury. Electronic I bonds can be purchased through a TreasuryDirect account, and paper I bonds can be purchased using your IRS tax refund. This type of bond is considered non-marketable, meaning they can’t be sold on secondary markets or held in a brokerage, IRA, or 401k account. 

I bond investment limits and penalties

Investors can directly purchase up to $10,000 worth of I bonds annually and an additional $5,000 using their tax refund, making the maximum annual investment $15,000 per person. This investment can take place all at once or in separate transactions. The minimum purchase amount is $25.

To receive interest, I bonds must be held for a minimum of 12 months. But if you want to get the most possible return, you have to hold the bond for five years; investors forfeit the last three months of interest payments if bonds are cashed out sooner. After five years, I bonds can be cashed out at any time with all accrued interest. Even though you won’t earn as much interest if you cash out early, your money is still quite liquid, as you can redeem your I bond any time without losing any of your principal investment. 

I bonds mature after 30 years, at which point they stop accruing interest. 

How I bond interest rates work

Once you understand what I bonds are, it’s important to understand how their interest rates work. 

I bonds earn interest monthly at a combined rate made up of the fixed and inflation rate. The interest rate is set twice a year (May 1 and November 1) based on the current inflation readings from the urban Consumer Price Index created by the U.S. Bureau of Labor Statistics. 

  • The fixed rate: This rate is determined by the Secretary of the Treasury and is announced in May and November. The fixed rate is applied to all Series I bonds purchased during the next six months and does not change through the lifetime of the bond. The fixed rate when you buy your I bond is the fixed rate that will be used to calculate its interest rate the entire time you own it. 
  • The inflation rate: The inflation rate is also announced in May and November and is determined by changes to the Consumer Price Index based on inflation. This rate is applied to the bond every six months from the bond’s issue date. The new inflation rate will be applied at the end of the six months. 

Together these two rates are used to calculate the composite or combined rate for I bonds. 

How to calculate the combined rate for I bonds

The formula for calculating the combined rate is:

[fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)] = combined rate  

For example, if the fixed rate is 0.90% and the semiannual inflation rate is 1.69%, the combined rate of the bond would be 4.30%. Here’s the equation with those numbers:

[0.90% + (2 X 1.69%) + (0.90% X 1.69%)] = 4.30%

Here’s how to do the math:

  • Convert the percentages into decimals: [0.009 + (2 x 0.0169) + (0.009 x 0.0169)]
  • Calculate the equations in the parentheses first: [0.009 + (0.0338) + (0.0001521)]
  • Add the three numbers within the brackets: [0.0429521]
  • Convert the decimal back into a percentage: 4.29521%
  • Round to the nearest hundredth: 4.30%

Because interest rates change twice a year, how your I bond accrues interest over time can be confusing. Your rate is only guaranteed for six months, after which the bond’s interest rate is applied to a new principal value made up of the prior principal and the interest earned in the previous six months. 

The minimum level that the interest rate can fall to is zero. If the inflation rate is so negative that it would take away more than the fixed rate, the combined rate simply falls to zero until the next adjustment period.

When I bonds pay interest

I bonds earn interest monthly, and the interest compounds semiannually. That means the interest you earn is added to your principal every six months, and you then earn interest on both your initial investment and the interest it has accrued. 

Here’s an example of how that might play out when the interest rate changes during the year:

  • Say you invest $100 in an I bond on May 1, and the combined interest rate is 4.30%.
  • Six months later, on October 31, you will have earned $2.13 in interest. The interest is compounded, so your bond is now worth $102.13.
  • On November 1, the I bond combined interest rate increases to 4.90%. For the next six months, you will earn that interest rate on your bond’s value of $102.13.
  • Six months later, on April 30, you will have earned $2.47 in interest, and your bond will be worth $104.60.

The longer you hold your bond, the more your interest can compound. When you cash out your bond, you receive your principal plus all the interest you’ve earned, minus any penalties. 

With electronic bonds, investors are paid automatically when the bond matures at 30 years if they haven’t already cashed it out. For paper I bonds, investors must submit the paper bond to cash it. You can see the current worth of your Series I bonds in your TreasuryDirect account at any time. 

I bonds and inflation

I bonds are considered inflation-protected because the composite rate keeps up with inflation. When inflation goes up, your interest rate does too. Since the interest rate never falls below zero, your initial investment is always safe. 

I bonds could be a hedge against inflation during periods when rates for interest-bearing accounts like savings accounts and CDs aren’t keeping up with inflation or when high inflation may have negative effects on securities like stocks. For example, I bond interest rates were at 9.62% through October 2022 and 6.89% through April 2023, when inflation rates were especially high. And, because of their security, I bonds can be a reliable source of diversification to help reduce overall portfolio risk and volatility. 

I bonds and taxes

Interest earned on your I bonds is subject to federal income tax; any federal estate, gift, and excise taxes; and any state estate or inheritance taxes. They are not subject to state or local income taxes, which many people see as an advantage to this type of bond.

Investors can also earn tax-deferred interest by waiting to report their interest earnings until the year they cash out the bond and the interest is actually paid out. You also have the option to report interest every year, despite not having received the money yet. This flexibility allows you to choose when you think it will be most advantageous to pay taxes on the interest you earn. 

Another potential tax benefit of I bonds is an educational tax exclusion. Investors can exclude part or all of their I bond interest earnings when:

  • They cash the I bond in the same tax year they claim the exclusion
  • They paid for a qualified higher education expense the same tax year for themself, a spouse, or dependents
  • They have a filing status that is not married filing separately
  • They have a modified adjusted gross income below $100,800 if single or $158,650 if married and filing jointly (as of 2022)
  • They were 24 or older before the bond issue date

If you want to take advantage of an educational tax exclusion, you might want to consult with a tax professional to understand how it might work for your particular situation. 

How I bonds are different than EE bonds

Both I bonds and Series EE bonds are issued by the U.S. Department of the Treasury. They share quite a few characteristics; the main difference is their interest rate. Where I bonds offer a fluctuating combined rate, EE bonds offer a fixed rate of interest that promises to double the value of the bond if held for 20 years. 

I BondsEE Bonds
InterestA combined rate that is adjusted with inflation every six monthsRate calculated at purchase to ensure the bond will double in value in 20 years
Years to maturity30 years20 years
Minimum purchase amount$25$25
Maximum purchase amount$15,000 per year $10,000 per year
TaxesInterest earned is subject to federal income tax, but not state and local income taxesInterest earned is subject to federal income tax, but not state and local income taxes
Guaranteed returnWill not lose an initial investment; return changes every six monthsGuaranteed to double in value by year 20

If you want to invest in more than one type of U.S. Treasury security, you can hold both I bonds and EE bonds. You can also invest in an ETF that includes various U.S. Treasury assets, such as the TFLO U.S. Treasury Income ETF.

I bonds pros & cons

I bonds have both advantages and drawbacks, and whether investors choose to utilize this inflation-protected instrument is largely determined by their goals, comfort with risk, portfolio makeup, and investment time horizon.

Pros of investing in I BondsCons of investing in I Bonds
Inflation hedge: Money won’t lose buying power because it will grow at the rate of inflationVariable rate: The initial rate is only guaranteed for the first six months of ownership, and interest rates could fall to zero
Competitive interest rate: Rates are especially competitive in times of high inflationWithdrawal penalties: If money is withdrawn after one year but before five years, you lose three months of accrued interest
Low risk: Because they’re backed by the U.S. Department of the Treasury, risk is extremely lowInvestment limits: At a maximum of $15,000 investment each year, your overall earning capabilities are restricted
Portfolio diversification: A less risky investment like I bonds can help balance more aggressive investments like stocksOpportunity cost: While generally safer, potential earnings can be much lower than stocks or other more risky investments

Risks of I bonds

Since they’re backed by the U.S. Department of the Treasury, which has never defaulted on its debt, I bonds are considered one of the lowest-risk investments out there. It is extremely unlikely that you’ll lose your initial investment. But no investment is entirely without risk. I bonds do pose two primary concerns for investors:

  • Opportunity cost: Due to the variable rate, the interest rate on your I bond could fall, even as low as 0%. In that case, you lose the opportunity to earn a better return elsewhere while your money is tied up in the bond. 
  • Early withdrawal: While you can cash out your bond at any time, you’ll lose out on some interest if you do so before five years, and you won’t earn any interest at all if you redeem your bond in less than a year. 

I bonds in your portfolio

I bonds might be worth considering for investors who:

  • Are looking for an inflation-stable investment
  • Want a very low-risk investment
  • Won’t need access to the money for five or more years
  • Are looking for a reliable investment to diversify their portfolio

I bonds might make less sense for investors who:

  • Are looking for high-growth or income opportunities
  • Are investing for retirement
  • Are looking for very short-term investments
  • Are hoping to make all their investments within a retirement vehicle (like a 401k or IRA) or in a brokerage account

What are I bonds’ place in your portfolio? 

I bonds can be a compelling choice for investors looking to fill the cash and fixed-income portion of a diversified portfolio. But, like all investments, it’s important to do your research before you buy to ensure you’re making the right choice for your investment goals and strategy. There are many high-yield investment opportunities to choose from, and I bonds may be just one of many options you pursue. Whether you move forward with I bonds or choose to pursue other bonds and stock combos, Stash can help you find the right balance for your portfolio so you can work towards your long-term financial goals.

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