With interest rates hovering at historic lows levels, its been quite a struggle to find a decent interest rate on your cash. Most of the banks are paying next to nothing and short-term treasuries are not faring much better.
Enter, The I Bond.
While we recommend that it is good practice that our clients have an “emergency fund” as part of their “Now Bucket”, the tradeoff of earning a near zero interest rate can become frustrating. And as inflation creeps higher, the money in the bank begins to lose purchasing power due to negative real rates (when the inflation rate is higher than the interest rate you earn).
One option to consider is a government issued I Bond.
While I Bonds are certainly not as exciting or exotic of an investment choice as something like cryptocurrency or other alternative investments, a boom in inflation has created an opportunity to capture high interest rates on these bonds while still providing the safety of a United States government savings bond. Government savings bonds are generally deemed risk free because they are backed by the full faith and credit of the federal government. Most investors feel confident that the U.S. government will not default on its obligations to bond holders.
With an I Bond, the interest rate is a combination of a fixed interest rate and the inflation rate. The current interest rate is 3.54%, but we anticipate this interest rate to rise once they re-establish the semi-annual inflation rate on November 1st.
For this reason, if you were going to purchase I Bonds, we would recommend waiting until after November 1st to see how the new rates shake out. The latest report showed that the CPI-U increased by 3.56% in the last six months (an annualized rate of 7.12%). The 7.12% rate should be the I Bond inflation component that will be announced at the start of November. This will be the highest I Bond inflation rate since the I Bond program began in 1998. Before this year, the highest rate had been 5.70% in November 2005. If an I Bond is purchased in October, you’ll get the current rate of 3.54% for six months before the potential 7.12% rate takes effect.1
Here is the “cliff note” summary, but for those of you that would like to learn more, keep reading past the summary:
- The maximum you can purchase each year is $15,000 as an individual (so you could invest up to $30,000 per year as a married couple).
- $10,000 can be electronically purchased online at any time by registering an account at: https://www.treasurydirect.gov.
- $5,000 can be purchased at the time of your tax filing using your tax refund.
- You can purchase up to $15,000 for each child, by gifting the I Bond to them. This can be done through the online account (Up to $10,000) or through your tax refund ($5,000).
- You must hold the I Bond for 1-year, so we would not recommend this for 100% of your Emergency Fund.
- The investment duration is 5-years for an I Bond, but if you redeem it early, you will only forfeit the last 3-months of interest. Because this forfeiture of interest isn’t significant, we like this as an investment even if you do not plan to hold for 5-years.
- The interest earned on an I Bond is subject to Federal tax but is exempt from state tax, producing an even greater after-tax internal rate of return for those of you in a highly taxed state like California.
- If proceeds are used for qualifying education and you are under certain AGI limits, the interest could be tax exempt at the Federal level as well.
So, let’s dive into the details.
The main purpose of an emergency fund is to have a stash of money set aside to cover the financial surprises life throws your way. These unexpected events can be stressful and costly. Here are some of the top emergencies people face:
- Job loss
- Medical or dental emergency
- Unexpected home repairs
- Car troubles
- Unplanned travel expenses
- Business opportunities
But wouldn’t it be nice to earn a little interest on this dormant cash sitting around for a rainy day?
Historically we have used money market accounts to balance liquidity and interest rates, but today these accounts still have very low yields.
While quick inflation increases are not something we typically like to see, there is an investment that has become more attractive as inflation rises.
The I Bond.
I Bonds are savings bonds introduced by the Federal government in 1998. They are a low-risk savings product. During their lifetime they earn interest and are protected from inflation. These savings bond earn interest based on combining a fixed rate and an inflation rate.
The I Bonds interest rate is a combination of a fixed rate that stays the same for the life of the bond and an inflation rate that is set twice a year. For bonds issued from May 2021 through October 2021, the combined rate is 3.54%. This rate will reset on November 1st and the latest report showed that the CPI-U increased by 3.56% in the last six months (an annualized rate of 7.12%). The 7.12% rate should be the I Bond inflation component that will be announced at the start of November. This will be the highest I Bond inflation rate since the I Bond program began in 1998. Before this year, the highest rate had been 5.70% in November 2005. If an I Bond is purchased in October, you’ll get the current rate of 3.54% for six months before the 7.12% takes effect.1
How does Treasury figure the I bond interest rate?
The interest on I bonds is a combination of
- a fixed rate, and
- an inflation rate
You know the fixed rate of interest that you will get for your bond when you buy the bond. That fixed rate does not change during the life of the bond.
Treasury announces the fixed rate for I Bonds every six months (on the first business day in May and on the first business day in November). That fixed rate then applies to all I Bonds issued during the next six months.
The fixed rate is an annual rate, but compounding is semiannual.
Unlike the fixed rate which does not change for the life of the bond, the inflation rate can and usually does change every six months.
They set the inflation rate every six months (on the first business day of May and on the first business day of November), based on changes in the non-seasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy.
However, the change is applied to your bond every six months from the bond's issue date. (The dates for these changes might not be May 1 and November 1.)
Combining the two rates
To get the actual rate of interest (sometimes referred to as the composite or earnings rate), combine the fixed rate and the inflation rate, using the equation in the example below.
- The combined rate will never be less than zero. However, the combined rate can be lower than the fixed rate. If the inflation rate is negative (because we have deflation, not inflation), it can offset some of the fixed rate.
- If the inflation rate is so negative that it would take away more than the fixed rate, they don't let that happen. They stop at zero so you cannot lose principal in an I Bond.
Here is an example of how the 3.54% current interest rate is determined:
- Fixed Rate: 0.00%
- Semi-Annual Inflation Rate: 1.77%
- Annual Rate: 3.54% (0.00% Fixed Rate + 3.54% Annualized Inflation Rate = 3.54% Composite Rate)
How do I bonds earn interest?
I bonds earn interest monthly from the first day of the month in the issue date. The interest accrues (is added to the bond) until the bond reaches 30 years or you cash the bond, whichever comes first.
- The interest is compounded semiannually. Every six months from the bond's issue date, all interest the bond has earned in previous months is in the bond's new principal value. Interest is earned on the new principal for the next six months. For example, in month seven, interest is earned on the original price plus six months of interest. In month 13, interest is earned on the original price plus 12 months of interest. (However, values displayed by the Savings Bond Calculator for bonds that are less than five years old do not include the latest three months of interest. These values reflect the interest penalty.) If you hold the bond for at least five years, when you cash in (redeem) the bond, you receive all the interest the bond has earned plus the amount you paid for the bond.
- You can redeem the bond after 12 months. However, if you redeem the bond before it is five years old, you lose the last three months of interest. (For example, if you cash a I bond after 18 months, you get the first 15 months of interest.)
If you have any questions about I Bonds or your general investment portfolio, please don't hesitate to reach out!
Dave Alison, CFP®, EA, BPC