There has been a lot of buzz about I Bonds (or to give them their full name, US Treasury Series I Bonds). As US government bonds, they are considered to be credit risk-free. As of early 2023, they are paying interest of 6.89%, free of state and local taxes.

Here’s what you need to know:

  • You buy Series I bonds electronically straight from the government and hold them safely online at Treasury Direct. If you do not already have an account, you can open one hereImportant: the website can be glitchy – when setting up an account, double-check that all the details you input are 100% exactly correct or you may be booted and forced to submit documentation by snail mail which can delay your account opening by many weeks.
  • You can easily set up single one-time purchases or schedule automated systematic recurring purchases throughout the year, subject to the annual limit (see below).
  • The interest rate is recalculated and re-set every six months and compounds semi-annually. There is a fixed component (which is currently 0.40%) and an inflation-indexed component. It is this second part that is tied to the Consumer Price Index (CPI) that resets semi-annually.
  • I Bonds earn interest monthly. Interest is compounded semiannually, meaning that every six months, the bond’s interest payment is added to a new principal value (the total of the prior principal value and the interest earned in the previous six months). Thus, the bond’s value grows both because it earns interest and because the principal value gets bigger.
  • The twice-a-year resets of the interest rate take place in in May and November and take into account the official CPI rate over the preceding six months and annualizes it, then adds it to the fixed component to determine the interest rate for the upcoming six months until the next reset. For example, if inflation had moved higher by about 0.5% per month every month for the six months preceding the re-set, that would be a total of about 3% for a six month period. Double that to annualize it and add the fixed component (currently 0.40%) and you would get an I Bond interest rate for the next six months of about 6.40%.
  • You don’t pay any state or local taxes on the interest and all the federal income tax can be deferred until you redeem the bond. This is in contrast to interest on savings or money market accounts paid by banks, brokers, credit unions, high yield savings providers etc. that is taxed every year at the federal, state and local levels.
  • If you use these bonds to pay for qualified education expenses, the interest can be federally tax-free under certain circumstances**.

** Income limitations apply to the availability of the federal tax exclusion on the interest for funds used for education purposes: total combined Modified Adjusted Gross Incomes above about $159k (2023) for joint filers and above about $101k (2023) for single filers will prevent the taxpayer(s) from getting this federal tax break, although the state and local tax exclusion will still apply.

The federal tax exclusion is also not available for any married taxpayers who choose to file separately. Nor is it available if the student was gifted the I Bonds or if the bonds were purchased in the student’s name before the student reached the age of 24 (so buying them in a minor child’s name now and having them spend it later on undergraduate education will not qualify for the federal tax deduction, although the state and local tax exclusion will still apply).

However (important!!):

  • You cannot cash in these bonds for any reason for twelve months after buying them. The funds are locked up for a year after the purchase date.
  • If you cash in between one and five years from the purchase date, you forego the last three months’ interest.
  • There is an annual $10k purchase limit per person (per social security number). This re-sets on January 1st each year.
  • You can use your federal tax refund to buy up to an extra $5k per year ($50 minimum) although you need to make this request in advance, at the time of filing. For some inexplicable reason, these will be issued in physical paper I Bonds, which you will then have convert to electronic I Bonds to get them into your online account.
  • You can buy another $10k annually in the name of each separate corporation (LLC, S-Corp etc) of which you are an owner. These bonds will be issued and held electronically in a separate account (EIN number of the corporation) from your personal account.
  • You can buy another $10k annually in the name of each minor child dependent, but I strongly advise watching this video before doing so, as there are a number of considerations and implications to doing this. These bonds will be issued and held electronically in a sub-account of your personal account.
  • You are not able to buy I Bonds in a tax-deferred account like an IRA or 401(k).
  • You cannot open joint accounts. Both spouses or partners would need to each create their own account. Each spouse or partner is subject to the $10k annual purchase limit, so $20k max purchases per calendar year per couple.

It is clear that these bonds are of interest during periods of high inflation and become less so as inflation gets lower. When comparing the interest to something like a High Yield Savings account, take into account the one year lockup period, the restricted purchase amount, the tax benefits of I Bonds and assess how they stack up with each other in your own very specific financial outlook and circumstances.

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See the original article at: https://simonbrady.substack.com/p/i-bonds-what-you-need-to-know

You can read more of my personal finance-related posts, including a weekly financial market report, at https://simonbrady.substack.com/