I bonds have earned their reputation as an inflation-fighting tool for retirees. As of May 2024, I bonds are returning 4.28%, which is lower than the same period in 2023 but still well ahead of the inflation rate of 3.5%. The previous I bond rate stood at 5.27%, set in November 2023.
What are I bonds, and how can they help retirees protect their assets against inflation? Let’s take a closer look.
— I bonds defined
— Risks and returns
— Laddering strategies
— I bond tax benefits
— Buying I bonds
— Top tips for investing in I bonds
I Bonds Defined
I bonds, or Series I savings bonds, are U.S. Treasury securities designed to protect investors from inflation.
“I bonds earn interest based on a fixed rate and a variable inflation rate, which is adjusted semiannually, in May and November,” said Andrew Latham, a certified financial planner in Rolesville, North Carolina, in an email. “The inflation rate is determined by changes in the Consumer Price Index for Urban Consumers (CPI-U). When you buy an I bond, you’ll receive the fixed rate that was in effect at the time of purchase throughout the life of the bond, while the variable rate changes with inflation.”
An I bond’s interest rate combines a fixed rate and an inflation rate, both of which are set by the Treasury Department.
“The inflation rate is adjusted semiannually based on changes in the Consumer Price Index for All Urban Consumers (CPI-U),” said John Bergquist, investment advisor and president of Elysium Financial in South Jordan, Utah, in an email. “The interest compounds semiannually and is paid when the bond is redeemed. However, if you redeem the bond before five years, you’ll forfeit the last three months’ interest. I bonds have a maturity period of 30 years, but you can redeem them after holding them for at least one year.”
Investors typically buy bonds because they tend to be less volatile than other assets, such as stocks, and they offer lower investment risk.
“I bonds became popular recently because inflation surged and the interest rate that I bonds pay is linked to inflation in the U.S.,” said Mark Johnson, teaching professor and investments and portfolio management fellow at Wake Forest University School of Business in Winston-Salem, North Carolina, in an email.
Bonds garnered major interest from investors coming out of the pandemic, with historically high interest rates. “When inflation was rising in 2022, investors were rushing to buy I bonds because they were paying almost 10% interest, which seemed like a no-brainer at the time for investors wanting a nearly double-digit return that was stable with minimal risk,” Johnson noted.
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Risks and Returns
Like any retirement-oriented investment vehicle, I bonds have upsides and downsides.
“A big plus is that I bonds provide a hedge against inflation because the interest rate adjusts based on changes in the CPI-U. They’re backed by the U.S. government, making them one of the safest investment options available,” Bergquist said. “Interest earned on I bonds is exempt from state and local taxes and can be deferred for federal taxes until redemption. You can purchase I bonds in denominations as low as $25, making them accessible to most investors.”
On the downside, the fixed-rate component of I bonds tends to be relatively low, especially during periods of low interest rates.
“While you can redeem I bonds after one year, there’s a penalty for redeeming them within the first five years,” Bergquist noted. “While you can defer taxes on the interest until redemption, you’ll eventually pay taxes on the interest accrued over the years. The maximum allowable investment in I bonds per calendar year per Social Security number (including purchases in both electronic and paper form) is $10,000 and up to $5,000 in paper I bonds, but only if you purchase it with your tax refund.”
“This limit applies to individual purchases, so a couple filing jointly could potentially invest up to $20,000 per year if they each buy bonds separately, plus the $5,000 extra with the tax return,” he added.
Laddering Strategies
Investors can build an I bond laddering strategy that maximizes investment returns and also builds in some risk protection up to and during retirement. A laddering strategy involves purchasing bonds with staggered maturity dates to spread out risk and provide liquidity.
“A laddering strategy typically involves buying bonds at regular intervals to spread out maturity dates and interest rates,” Latham said. “In the case of I bonds, consider buying them yearly to ensure continuous protection against inflation and provide liquidity as each batch matures past the five-year mark, avoiding the penalty of the last three months’ interest forfeiture. This way, you can benefit from varying interest rates and improved access to funds without significant penalty.”
[READ: How to Build a CD Ladder for Retirement]
I Bond Tax Benefits
I bonds also provide tax deferral on earned interest income.
“For example, suppose you invested $100 in an I bond that yielded 5% for 30 years,” said Roger Silk, CEO of Sterling Foundation Management in Reston, Virginia, in an email. “After you paid the tax at the end of year 30, assuming a 22% tax rate, you would keep about $359. In comparison, if you paid tax each year, you’d have about $315 at the end of year 30.”
Any interest earned on I bonds is subject to federal income tax but exempt from state and local taxes.
“An additional benefit is you can choose to defer federal taxes until you redeem the bond or it reaches maturity,” Latham said. “This flexibility can be beneficial for tax planning, especially if you expect to be in a lower tax bracket in the future. Note that if you use I bonds for educational purposes, you may be eligible for tax exemption on the interest earned.”
Buying I Bonds
I bonds can be purchased directly from the U.S. Treasury through TreasuryDirect.
“You need to create an account and can buy bonds electronically,” Latham advises. “The annual purchase limit is $10,000 per Social Security number.” Since 2010, the IRS has allowed filers to use their federal income tax refunds to purchase up to $5,000 in paper I bonds.
[READ: 10 Essential Sources of Retirement Income]
Top Tips for Investing in I Bonds
I bonds are best suited for long-term investors due to their inflation protection features and the penalty for early redemption.
“The fixed rate and inflation rate of I bonds change periodically, so stay informed to make informed investment decisions,” Bergquist said. “While I bonds offer safety and inflation protection, they may not provide the highest returns. Consider diversifying your portfolio with other investments to balance risk and return.”
It’s also a good idea to leverage I bonds within your household budget. “Since I bonds cannot be redeemed within the first year and incur a penalty if cashed within five years, make sure these restrictions match your cash flow,” Latham said.
Additionally, consider using I bonds for educational savings. “The tax exemption for using I bonds for educational purposes can significantly enhance the tax efficiency of your investment,” Latham said. “Also, keep an eye on inflation trends to maximize return.” Since the rate adjustments are based on inflation, monitoring economic forecasts can help you anticipate changes in your bond’s performance.
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Are I Bonds a Good Investment for Retirees? originally appeared on usnews.com
Update 05/03/24: This story was previously published at an earlier date and has been updated with new information.
