In most cases, there's a clear trade-off in investing. If you want the possibility of higher returns, you have to accept higher risks. There is one investment, however, that's expected to soon offer returns that annualize to a 9.62% rate of return, while carrying a U.S. government-backed guarantee of payment. That investment? I-Bonds.
I-Bonds are 30-year U.S. government bonds that pay a fixed rate of return plus an inflation-adjusted rate of return. The fixed rate is currently at 0%, and on May 1, the inflation-adjusted rate of return is expected to increase to pay out at that 9.62% annualized level. That makes I-Bonds a way to earn a virtually risk-free annualized return near 10%, but of course, there are strings attached to that investment.
What's the catch?
One catch is that every individual is able to buy only $10,000 worth of I-Bonds per year electronically through TreasuryDirect, plus another $5,000 of paper I-Bonds if bought via a tax refund. That makes I-Bonds useful but limits their scope in the fixed-income portion of an investor's portfolio.
Another -- and potentially much bigger -- catch is that once you buy an I-Bond, you must hold on to it for at least a year. You are not allowed to sell sooner than that time period, which means your money is locked up for at least that long. That makes it difficult to recommend I-Bonds as a source of emergency fund money, since the point of an emergency fund is to have cash available when you need it.
As if that weren't enough, you really only get the advertised returns on your I-Bonds if you hold on to them for at least five years. If you sell before then, you forfeit the last three months' of interest accrued on the bonds.
On top of tall that, the U.S. Treasury adjusts the returns that I-Bonds offer every six months, based on recent inflation rates. That means that while I-Bonds bought between May and October of 2022 will probably earn that high rate of return for six months, their future returns will depend on inflation.
And of course, the interest you earn on I-Bonds is considered ordinary income -- and taxed accordingly on a federal level, unless you use the I-Bonds to pay for higher education expenses in a qualified way. On a brighter note, you can defer those taxes until you redeem your I-Bonds or they reach final maturity.
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So whom do I-Bonds make sense for?
Those catches make the reality of owning I-Bonds a bit less attractive than the headline potential returns indicate. That doesn't mean they're worthless, however. It does mean that you need to figure out how they can play a reasonable role in your portfolio given the catches and restrictions associated with owning them.
One way that they can play a role is if you expect inflation to remain high for years to come while you also expect the stock market to remain rocky over the same period. In that world, I-Bonds can be a reasonable parking place instead of cash, since that money should at least come close to keeping up with inflation (after taxes and the potential early redemption penalty).
In addition, one key financial guideline to remember is that money you expect to spend within the next five years does not belong in stocks. If you know of a substantial expense coming up around five years from now -- such as your child's education, a balloon debt payoff, or a new car purchase -- then I-Bonds can be a great place to hold that cash. Even with the strings attached, I-Bonds' rates are currently higher than most similar-duration investment-grade bonds are, making them an attractive alternative.
I-Bonds may also play a role as you're planning for your children's educations, because you might be able to exclude I-Bonds' interest from your income if using them to pay for college costs. That said, there are key restrictions to that benefit, including these:
- Your income must be below $98,200 if single or $154,800 if married filing jointly.
- You must be at least age 24 when you buy the I-Bonds,
- You cash in the I-Bonds the same year you're paying for the college costs.
Given those restrictions, it makes sense to consider I-Bonds as a potential source of college savings only after you've maxed out the tax benefits of a 529 plan. After all, kids' college often hits near their parents' peak earnings years, and a high enough income will eliminate that tax benefit of using I-Bonds for college costs.
Get your plan in place today
If you're thinking of investing in I-Bonds as part of your plan to combat inflation, it is important that you have a decent end-to-end strategy in place before you do. This is because the per-year purchase limit, the one-year minimum holding period, and the potential loss of interest for early withdrawals make them most appropriate for surgical-style use. So get your plan in place today, and give yourself a decent chance of seeing at least some of your money have a shot of keeping close with inflation.
