2022 has started out as a very rough year for most Americans. The stock market is down  while inflation is up  and wages have shown signs of stagnating. That combination has strained people's purchasing power throughout the country.

In that environment, I-Bonds, with their promise of inflation-matching returns, look like a promising island of stability and value protection in an otherwise very stormy situation. In reality, while those headline numbers look promising, the details behind them make I-Bonds a less ideal investment than they seem on the surface. That's not to say they're a bad use of your money, just one where the actual reality may not live up to the headline promise in most scenarios.

Paper I-Bonds

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Some key limitations of I-Bonds

First, each person is limited to $10,000 of direct I-Bonds purchases per year, plus an additional $5,000 if purchased via a tax refund. That limitation means that while I-Bonds might play a role in your financial plan, you should not expect them to be able to use them to protect truly life-changing amounts of your money from inflation.

In addition, once you buy an I-Bond, your money is tied up for at least a year,  unless you happen to live in a declared disaster area. That makes it important to have an alternative source of emergency money for at least that first year after buying an I-Bond. Otherwise, if you have an unexpected need to tap your cash early, you might find that the interest you're paying to borrow while waiting for that timer to pop exceeds what you're earning on the I-Bond.

As if that weren't enough, if you cash in your I-Bonds before you've held them for five years, you will forfeit the most recent three months of interest. In other words, to truly get I-Bonds' inflation-matching promised returns, you must hold your I-Bonds for at least five years. Any shorter holding period means you will get less than that headline number. This is important to realize, since a five year time horizon is around the time when it starts to make sense to invest in stocks as a means to try to beat inflation.

Then, of course, there are the taxes. While exempt from state taxes, the money you earn on I-Bonds is taxed as ordinary interest income at a Federal level. As a result, your headline returns may keep up with inflation, but your purchasing power on that money likely will not.

Put it all together, and I-Bonds become tools that have some use, but aren't necessarily a great alternative for all other uses of cash or bonds.

So where do I-Bonds make sense?

I-Bonds can be a useful tool as you're shifting money from stocks to cash or bonds a few years before your kids start their college educations. This is because you can often exempt the interest on I-Bonds from your income for tax purposes if you're using the money to pay for qualified education expenses. 

In addition, I-Bonds can be useful in a bond ladder, particularly if you have at least a five-year time horizon. This is because you can defer the tax on the interest received on an I-Bond until you sell it, which leads to less annual internal drag on your returns than with standard bonds. Be aware, though, that I-Bonds interest adjusts every six months, so if inflation gets back under control, the current rate of return you get on your I-Bonds will shrink.

Finally, if you are saving for a goal that's more than a year out and would otherwise be saving in a checking or savings account, I-Bonds could offer you a better risk-adjusted return on your money. Remember that I-Bonds are securities offered by the United States Treasury. If the U.S. government stops paying its bondholders, we've probably got bigger problems on our hands than just the missing money.

If you're going to use I-Bonds, get started now

Ultimately, I-Bonds can serve a reasonable purpose as part of your overall financial plan. The one-year minimum holding period means that the sooner you buy them, the sooner that clock starts ticking. So if you're planning to use I-Bonds, now is a great time to put your plan in place to make them a part of your overall portfolio.