Investing

What Are I Bonds and How Do They Work?

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Series I bonds are savings bonds issued by the U.S. Treasury with an interest rate tied to inflation. I bonds are a low-risk investment with a longer time horizon: you can’t cash them in until a year after your purchase, and you pay an interest penalty if you cash them in before five years.

You must buy I bonds through the U.S. Treasury, which has issued them since 1998 to help protect savings from eroding during periods of high inflation. There are some annual limits to how much you can invest in I bonds.

Current I bond interest rate: 9.62% through October 2022

In an inflationary environment, I bonds provide investors with a strong guaranteed return, as long as they’re willing to sacrifice short-term liquidity.

How do I bonds work?

The U.S. Treasury sells Series I savings bonds directly to investors as a low-risk and guaranteed way to grow their money for up to 30 years. Each year, investors can purchase up to $10,000 in electronic I bonds via the Treasury Direct website and up to $5,000 in paper I bonds through the mail when filing federal income taxes. U.S. citizens, residents and civilian employees — plus trusts, estates, and other entities — can purchase I bonds.

New I bond rates are set at the beginning of May and November. They fluctuate with inflation, so they’re subject to change over time. Interest rates are calculated with a combination of a fixed rate set at the time of bond purchase and a variable rate based on the Consumer Price Index for all Urban Consumers (CPI-U).

The composite interest rate for I bonds is calculated as:

fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)

The current rate of 9.62% is calculated as:

0.00% + (2 x 4.81%) + (0.00% x 4.81%)

The fixed rate has been set at zero since 2020.

When you first purchase an I bond, its interest rate applies for the first six months of the bond, and your I bond rate will continue to change every six months. For example, if you buy an I bond in June, the bond will maintain the same rate until its next rate takes effect six months later in December.

Interest is also compounded every six months on I bonds. Because the fixed rate on bonds is subject to change, the current earnings rate on I bonds may be different depending on when they were purchased.

I bonds are designed as long-term savings vehicles, so:

  • I bonds cannot be redeemed until a year after their purchase.
  • If you redeem an I bond within five years of purchase, there is a three-month interest penalty.
  • I bonds continue to accrue interest until they mature after 30 years.

It’s difficult to project exactly how much an I bond will be worth over time, but they are guaranteed to at least preserve the real value of the bond. “One advantage I bonds have over regular bonds is that you can redeem them after the first year without the possibility of a loss. For regular bonds, you may have to sell them at a loss if interest rates have risen,” says Ken Tumin, senior industry analyst at MagnifyMoney.

Pros and cons of I bonds
Pros Cons
Interest rates tend to exceed typical rates on deposit accounts like certificates of deposit (CDs) Small annual purchase limits for electronic and paper I bonds
Interest rates are guaranteed to keep pace with inflationI bonds cannot be redeemed for at least a year
No state or local income taxes on interestPurchasing I bonds through the U.S. Treasury can be confusing and time-consuming

How to buy I bonds

To purchase an I bond online, set up an account with TreasuryDirect. You’ll need your taxpayer ID number (which is often a Social Security number), a U.S. address of record, a checking or savings account and an email address to open a TreasuryDirect account. Once you’ve opened an account, you can purchase electronic I bonds.

You can also purchase I bonds when filing your federal income tax returns. In order to purchase those paper I bonds, you’ll have to file IRS Form 8888, which allows you to elect to use part of your income tax return to buy them.

“One big difference between the I bond and a standard bond is that savings bonds are not marketable securities, so you can’t buy and sell savings bonds from a brokerage firm,” says Tumin.

However, buying I bonds from the U.S. Treasury can sometimes be difficult. During the process of opening a TreasuryDirect account, ID verification can be a roadblock. “TreasuryDirect may require that the applicant mail in a paper form,” according to Tumin, which “requires a signature guarantee from a financial institution.” Since many banks and credit unions don’t offer that service, it can be a challenge to obtain that signature guarantee and submit the form.

How to cash in I bonds

Once you’ve held an I bond for a year, you can cash it in, but at a price — you’ll pay a penalty of three months’ interest if you cash it in within five years.

You can cash in electronic I bonds through the TreasuryDirect website. You don’t need to cash in the entire value of the bond at the same time. You’ll receive your funds via a direct deposit into your bank account.

You can cash in paper I bonds at some banks (but not every bank will cash savings bonds). If that isn’t an option, you can send them to Treasury Retail Securities Services along with FS Form 1552. You may need to verify your identity, which can be a cumbersome process.

I bond taxes

Once you cash in an I bond, you must pay federal taxes on the earned interest unless the funds are used for certain educational expenses. TreasuryDirect will provide a 1099-INT form to report that income on your federal income tax return. State and local income taxes don’t apply to I bond interest.

Tumin notes that I bonds have tax advantages relative to other investments and certificates of deposit (CDs): You can defer taxes on the interest until it matures or until you cash it in. “Federal taxes on regular bonds held outside of retirement accounts cannot be deferred like this.”

Are I bonds a good investment?

I bonds are a safe, reliable way to outpace inflation and are designed for small investors, according to Tumin. Relative to CDs, which currently pay much lower interest rates, I bonds provide investors with a much better yield and will likely continue to do so until the post-pandemic inflation spike subsides.

Tumin notes that I bonds are a useful way to obtain some inflation protection for your savings, and that they can be a useful savings product to supplement your emergency fund. I bonds are a safe, reliable investment if you know you won’t need the money for several years and want to avoid having inflation eat away at the value of your entire savings.

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Reviewed By: E. Napoletano