I’ve had a number of requests to do a post on I Bonds over the last year or so. Up until now I hadn’t really gotten around to it for a couple of reasons. First, it’s tough to get excited about most bonds these days (except Peer to Peer Loans) due to low yields and poor recent performance. I certainly am still a bond investor, but they’ve definitely been sitting on the back burner lately.
Second, I Bonds can really only be held inside a taxable account. Regular readers will recall I don’t really own much of a taxable account. I’ve got a rental property, some shares of an LLC that owns my business building, tiny accounts at Lending Club and Prosper, my savings account at Ally, and a checking account, but I haven’t had what I would describe as a “taxable investing account” since arriving at my current job. I’m blessed to have access to enough tax-advantaged accounts that I can shelter nearly all of my investing inside my 401K/Profit-sharing Plan, my Solo/Individual 401K for The White Coat Investor, a Defined Benefit/Cash Balance Plan, Personal and Spousal Backdoor Roth IRAs, an HSA, and 529s. So….no taxable account….no ability to buy I bonds….no reason to buy I bonds. My inflation-indexed bond of choice has been TIPS, simply because I can buy those in a tax-protected account. But I know many of you may benefit from buying I Bonds, so let’s talk about them.
Inflation-Protected US Government Savings Bonds
The US Government issues two types of Savings Bonds, “Series EE” and “Series I.” The EE bonds have been issued since 1982 when they were yielding 13.05%. Unfortunately, they now yield 0.10%. While it is hard for me to get excited about my savings account yielding 0.86%, it’s 8 times better than the current yield on EE bonds. EE bonds are not indexed to inflation in any way.
I bonds, however, are similar to TIPS in that there are two components to the yield. One component is fixed at the time you purchase the bond. It is set for new bonds every 6 months. If you buy an I bond right now, the fixed rate is 0.20%. If you bought it in 2000, you could have gotten 3.6%. The other component varies with inflation and changes with the CPI-U (non-seasonally adjusted, includes food and energy). It is changed every six months and then combined with the fixed rate of your particular bond in an interesting, but not straightforward way. The combined rate can be lower than the fixed rate, but never lower than zero and changes every 6 months on the 1st of the month of the day you bought the bond (January 1st for bonds bought in January) and the first of the month 6 months later (July 1st for bonds bought in January). The current inflation rate is 0.59% but it has varied from 2.85% to -2.78%. Keep in mind that is a “6 month inflation rate” so the calculation to get your composite rate actually doubles that. There is one other factor in the calculation (the fixed rate multiplied by the inflation rate), but it rarely affects things much so you can essentially ignore it, at least these days. Here is the calculation:
Composite Rate = Fixed Rate + 2 * Inflation Rate + Fixed Rate * Inflation Rate
So on a recently issued I bond
1.38% = 0.20% + (2 * 0.59%) + (0.20% * 0.59%)
and on an I bond bought back in 2000
4.80%= 3.60% + (2 * 0.59%) + (3.60% * 0.59%)
I’m not sure I really understand the point of that last factor, since it only adds a basis point or two to the yield, but that’s the formula. Obviously, 4.80% is pretty good, and 1.38% isn’t. So the fixed rate when you buy I bonds is all important to their eventual return. For the last 2 1/2 years that fixed rate has been 0%. Now you know why people have a hard time getting excited about these things. You get to keep up with inflation (at least inflation as defined by the government), but that’s it unless you buy a bond with a halfway decent fixed yield. The yield compounds semi-annually, not daily like most savings accounts, which has the effect of slightly lowering your return.
Benefits of Savings Bonds
There are some minor tax benefits to buying savings bonds, both EE and I. First, the income grows in a tax-deferred manner for up to 30 years. There are no distributions like with a CD, a savings account, or a typical bond. They’re a little bit like “zero-coupon bonds” that way, except you don’t have to pay tax on phantom income like you would with a Zero or even a TIPS in a taxable account. When you finally do redeem the bond, the interest is taxable at your usual federal marginal tax rate, but free of state or local income tax just like all treasury bonds. However, if you use the entire proceeds (both principal and interest) to pay for qualified educational expenses, the interest is also federal income tax-free. Unless you’re a doctor. Then you’re probably out of luck because your income is too high to get that tax break which is phased out completely at a modified adjusted gross income of $84,950 ($134,900 married.) You can’t even just let your kids buy the bonds, because they have to be bought by someone at least 24 years old in order to get the educational expense tax break. However, if for some reason you have I bonds, and you are below the income limits this year but don’t expect to be later, you can redeem them now and put the money into a 529 plan, which is considered a qualified educational expense.
What’s the Catch?
The main issue with using savings bonds is that they’re a pain to buy and to redeem. You used to be able to buy “paper I bonds” at a local bank. You just walked in the door, plopped down 50 Benjamins, and walked out the door with $5K in I Bonds. As of 2012, you can’t do that anymore. The only way to get paper I Bonds is as part of a tax refund. You can deliberately overpay your taxes by $5K (per person) and then get the refund as an I Bond. If you don’t want to do that, your only recourse is to buy I Bonds directly from Treasury Direct. You can E Bonds, TIPS and other treasuries this way too if you like, although I find it well worth the 10-20 basis points a well run passive mutual fund or ETF charges to take the hassle of buying and selling individual bonds away from me. Unfortunately, there are no Savings Bond mutual funds, so if you want them, you have to buy them individually. So you open an account at Treasury Direct, and buy up to $10K in I Bonds per year per person. So if you actually wanted $200K of your portfolio in I Bonds, it might take you a decade or more to get there.
You can also redeem your electronic I Bonds at Treasury Direct (remember to do so before they hit 30 years old, since they stop earning interest then.) You may also redeem your paper I Bonds at many local banks. However, you cannot redeem bonds in less than 1 year, and if you redeem them in less than 5 years, you lose 3 months worth of interest.
Remember to always buy Savings Bonds at the end of the month and to sell them at the beginning of the month to maximize your returns. (You get credit for owning them for the whole month even if you only own them for a day.)
I Bonds Vs TIPS
The natural question an educated reader will have is “What about TIPS?” TIPS work a little bit differently than I Bonds, but the same basic principles apply. There is a fixed portion and an inflation-linked portion. Both are linked to CPI-U. Both are state and local income-tax free. TIPS do not have the tax-deferral feature of interest, and they can also generate phantom income, on which you owe real taxes, so they’re generally best held in a tax-protected account.
It is relatively easy to compare TIPS to I Bonds to determine which is the better deal. Since both are indexed to CPI-U, you just have to look at the fixed rates. Since you can hold I Bonds for up to 30 years, you can just compare a 30 year TIPS to an I Bond. As of this writing, a 30 year TIPS yields 1.41% real, and an I Bond yields 0.20%. That was an easy decision. Especially since you can easily buy and sell TIPS in any amount, and hold them within a mutual fund or ETF. Even 10 year TIPS yield 0.50% real. I guess if you were to compare an I Bond to a 5 year TIPS (-0.33%) or a 7 year TIPS (0.20%), then they look pretty good. You can also compare them to commonly held TIPS mutual funds (which tend to hold shorter-term TIPS) and they don’t look too bad either. I find both I Bonds and short term TIPS equally unattractive at these low real yields, but at least if rates go up you can redeem the I Bonds and buy new ones, whereas you’ll take a hit on the principal of the TIPS. (Of course, if rates fall, you get a boost on the principal of the TIPS.) Plus, even if you decide to redeem your old I Bonds and buy new ones, you’re still limited to just $10K per person per year (plus the $5K from your tax return.)
So Why Would I Want To Use I Bonds?
There are really four ways people use I bonds, but none of them are particularly wonderful, especially given today’s low fixed rates. The first is as an educational savings plan. This is kind of silly, however. 529s give you the exact same federal tax treatment, plus a possible break on your state taxes. If you have already maxed out your 529 contributions per year ($14K per spouse, per child) it is unlikely that you have an income low enough that you’ll get the educational tax break on your I Bonds. So that’s not a very good reason to buy I bonds.
The second use is as an emergency fund. Instead of earning 0.86% at Ally Bank, or buying some CDs yielding 1-2%, the investor figures, hey, why not put some of my emergency fund into I Bonds? It gives you some inflation protection and the possibility of higher yields. The downsides are that you can only buy a limited amount each year (and can’t buy back the ones you sell), you can’t redeem them for at least a year, if you redeem them in less than 5 years you forfeit 3 months of interest, and they’re a pain to buy and redeem compared to a simpler solution like a savings account. Besides, the point of an emergency fund isn’t to get a maximum return on that money. Not a great reason to buy I bonds, but if you have some you bought a few years ago, sure, feel free to use them as part of your emergency fund.
The third use is to “expand your tax-protected space.” Many investors have a large taxable account in comparison to their tax-protected accounts. Since I Bonds grow with the interest tax-deferred, some investors figure that owning them is a lot like having more tax-protected space. This is a little bit silly. You can always expand your tax-protected space by using a non-deductible IRA, making after-tax (not Roth) contributions to a 401K, or buying a variable annuity. Each of those can then be used to buy asset classes that are a pain to hold in a taxable account, like REITs and TIPS. But don’t think you’re getting some huge benefit for doing so, since just like buying I Bonds you get no up-front tax break for contributing to them and your withdrawals are fully taxable. These types of “tax-protected space” are very much inferior to a 401K or Roth IRA, and in many situations, inferior to a simple taxable account. You just get tax-deferred growth, which is a pretty limited benefit by itself.
The fourth use is as part of the inflation-indexed bond portion of your portfolio. As I see it, this is really the only good reason for most doctors to bother with I Bonds. Given today’s low yields on bonds (and thus low expected returns) many doctors willing to run the numbers will find that owning stocks in tax-protected and owning bonds in taxable is the right way to go for now. If you wish to own inflation-protected bonds, it therefore makes sense to buy some I Bonds in that taxable account. There is still the issue that you can’t buy very many of them, but that’s no reason they can’t at least be part of the solution. You can buy as many I Bonds as they’ll sell you, and make up the rest of that portion of your asset allocation with TIPS.
Overall, Series I Bonds can make up a valuable portion of your fixed income asset allocation. But don’t feel like you missed out on a great deal any time recently. It has been 5 years since they had a fixed rate of at least 1% and 10 years since they had a fixed rate of at least 2%. But if you ever see them going for 2-4% again, back up the truck.
Don’t dismiss EE bonds so quickly. If you hold them for 20 years, they double in value, a return of just over 3.5% annually. That might look pretty good if we’re in for a Japan-like 20 years of low interest rates. I wouldn’t bet the farm on it, but it may not be a bad hedge.
Good point. That’s better than the 20 year guaranteed returns for whole life. 🙂
I see the rate on treasury direct as 0.1% today. I guess they do guarantee a minimum doubling in 20 years though don’t they, even though the current rate is 0.10%. If you hold it less than 20 years, you don’t get the 3.5%, you get the 0.1%.
Yeah, it’s basically a late withdrawal penalty instead of the more common early withdrawal penalty.
I haven’t got to the point where I’d like to have more than $20,000/year in I-bonds, most of our savings is tax deferred. But, if I did, I’d seriously consider EE-bonds.
Thanks for the great blog! I think I found you shortly after you started. I’m not a doc, but my wife is. She’s too busy and not that interested in this stuff, she just wants to retire in 15-20 years. I like doing this, so I’m trying to learn and get us there. I think we’ve got a pretty good start and your blog helps quite a bit.
I have a hard time getting excited about an investment that I have to hold for 20 years to earn 3-4% on. I hold a few bonds in my portfolio, but I hope they’ll be earning more than 3% a year at some point in the next 20, and I can cash out of them at anytime.
I have filed up tax protected space and am saving in taxable account. I have been putting stocks/REIT in tax protected space due to current environment. Trying to determine which bonds to put in taxable account. Instead of TBI and TIPS. Would you use intermediate grade muni bonds instead of TBI ( I am in a high tax bracket). For a tips equivalent would you use I bonds (granted I could only get a limited amount) short term muni bonds or limited term munis. At least 20 years to retirement.
Thanks.
I think you’re thinking the right way. Putting munis + I bonds in taxable is wise. Alternatively, you could put a few tax-efficient stock funds (TSM, TISM) in there and put some TIPS into the tax-protected accounts. Given current interest rates, tax location matters much less than it used to.
Hi,
I bought ibonds instead of muni as the interest rate of ibonds was 1.94% (0% fixed), that was somewhat same in comparision to after tax return of intermediate muni, but there was no chance of loosing money with ibonds and more creditworthy compared muni.
so bought ibonds. does that reasoning sound good? should i prefer muni over ibonds for next year ?
Thanks.
I think your reasoning is fine. I just have a hard time getting excited about anything paying less than 2%.
Neat comparison of I Bonds vs TIPS. What was the TIPS rate in 2000 when I Bonds were bringing in 4.80% ? Did I Bonds “win” then?
Grammar police (I think you are missing a word? Confusing sentence.): “You can E Bonds, TIPS and other treasuries this way too if you like, although I find it well worth the 10-20 basis points a well run passive mutual fund or ETF charges to take the hassle of buying and selling individual bonds away from me.”
TIPS peaked at around 4%. Technically, I think TIPS won anyway as rates fell over the next few years giving the TIPS a boost that I bonds don’t get from falling rates.
Yes, there should be a “buy” in there somewhere.
“The third use is to “expand your tax-protected space.” Many investors have a large taxable account in comparison to their tax-protected accounts. Since I Bonds grow with the interest tax-deferred, some investors figure that owning them is a lot like having more tax-protected space. This is a little bit silly. You can always expand your tax-protected space by using a non-deductible IRA, making after-tax (not Roth) contributions to a 401K, or buying a variable annuity. Each of those can then be used to buy asset classes that are a pain to hold in a taxable account, like REITs and TIPS. But don’t think you’re getting some huge benefit for doing so, since just like buying I Bonds you get no up-front tax break for contributing to them and your withdrawals are fully taxable. These types of “tax-protected space” are very much inferior to a 401K or Roth IRA, and in many situations, inferior to a simple taxable account. You just get tax-deferred growth, which is a pretty limited benefit by itself.”
Say you’re in a high marginal bracket, both for federal and for state income taxes. You’re already maxing out your 401k, have no ability to make after-tax contributions to a 401k, and no interest in buying a variable annuity (too complex). I Bonds give tax-deferred growth and no state and local taxes upon withdrawal. Aren’t they then superior to a taxable account? Easier than holding TIPS in taxable, because you don’t have to pay taxes on phantom income, easier than holding STRIPS in taxable for the same reason. Perhaps equivalent to holding simple Treasuries in taxable, but with inflation protection.
If you want inflation protected bonds and have to hold them in taxable, then sure, I bonds are great. Hard to get very excited about them at current yields though.