It’s no secret: inflation is on the rise. And while it’s been a popular topic of conversation and speculation, the important thing is to understand how it affects your long-term financial plan and what you can do to maximize the value of your dollar.
One downside to inflation is that any cash you leave in a bank account loses its purchasing power over time. The primary way to combat this issue is to invest the cash so it has the opportunity to yield a greater return, helping your money keep pace with inflation. Of course, there are risks to investing in the stock market, so you might look for safer options to preserve your purchasing power.
That’s where I bonds come into play—these bonds can enhance your overall financial plan by providing a safer way to earn a yield that keeps pace with inflation.
What is an I Bond?
I bonds are a type of U.S. savings bond that are designed to help investors’ savings keep pace with inflation. They do so by leveraging a composite interest rate composed of both a fixed rate and an inflation rate that changes every six months according to fluctuations in inflation.
How Can I Bonds Improve My Portfolio?
The primary benefit of I bonds is that they help your savings earn more interest during times of high inflation. They’re also a safe investment because they’re issued by the U.S. Treasury, and as long as inflation rates are high, they can provide the highest yield of any government security.
I bonds also offer some tax benefits—they’re exempt from state and local taxes, so investors only have to pay federal income tax on their I bonds’ interest. You can choose to pay the tax annually, at maturity, or when the bond is cashed. If you use I bonds to fund college tuition, they can be completely tax free, making them an attractive option for a college savings plan.
How Are I Bonds’ Interest Rates Determined?
I bonds earn interest monthly and are compounded semiannually. Once purchased, each I bond’s interest rate will adjust every six months from the date it was issued according to the current inflation rate. To determine an I bond’s interest rate, the U.S. Treasury uses a composite rate based on two factors:
- Fixed Rate: The Treasury announces the fixed rate every six months. This rate applies to new bonds issued during the following six months, and it does not change during the life of the bond.
- Inflation Rate: The Treasury establishes the inflation rate every six months (in May and November) based on the Consumer Price Index for All Urban Consumers (CPI-U). This rate can (and usually does) change every six months.
I bonds’ interest rates are then calculated with the following formula: [Fixed Rate + (2 x Semiannual Inflation Rate) + (Fixed Rate x Semiannual Inflation Rate)] = Composite Rate. The current rate for I bonds (through May 1st, 2022) is 7.12%.
One benefit of I bonds is that the composite rate will never be below zero—however, in periods of deflation, it can be lower than the fixed rate. Similarly, while the fixed rate (which is constant for the lifetime of the bond) can provide some stability, it can become a disadvantage for I bond investors if interest rates increase—because they won’t benefit from the higher fixed rate.
How Can I Implement I Bonds in My Financial Plan?
You can purchase I bonds from the U.S. government on the TreasuryDirect website. Each year, investors are allowed to purchase up to $10,000 in I bonds directly, plus an additional $5,000 with their tax return (equaling $15,000 total). I bonds have a 30-year maturity term, but investors can cash out prior to the maturity date. However, there are some stipulations to cashing out early:
- You must hold an I bond for at least one year before you can cash out.
- To receive all your earned interest, you must hold the bond for a minimum of five years. If you cash out between years two and five, you lose the previous three month’s interest.
How Do I Know if I Bonds are Right for Me?
Like most financial strategies, the key is to be informed about your decision. It’s important to understand how I bonds will affect your overall financial plan. You’ll want to consider the interest rate and how it can change, the tax impact (like how you’ll be taxed and when), and the penalties for cashing out early.
If you’re curious about I bonds and other ways to preserve your purchasing power during periods of high inflation, we’d love to speak with you. As financial advisers, we can show you both the short- and long-term impact of using I bonds and help you determine if they’re an advantageous addition to your plan. If you’d like to know more about I bonds or want to review your financial strategies, you can schedule a meeting with one of our advisers here.
This article is intended to be for general information about the topic(s) described only, and should not be used as financial advice specific to your situation. For financial advice pertinent to your lifestyle, goals, risk tolerance and opportunities, please contact a financial professional.