I Bonds: What are They and Should You Buy Them?
I bonds are a popular investment strategy, and they have better rates of return than your piggy bank.
I bonds have become a common investment strategy in the past couple of years, especially as inflation rose after the pandemic. In fact, they’ve become so popular the Treasury Department’s website temporarily went down at the end of October due to the demand! But what exactly are I bonds? Are they for you? We’ll dig into the specifics below and connect you with other resources to learn more.
I bonds are savings bonds that earn interest from a rate partially tied to inflation and must be held for at least one year from the issue date before they can be cashed.
You can buy up to $10,000 in electronic I bonds each year, and an additional $5,000 in paper I bonds with your federal income tax refund.
Interest earned on I bonds is usually exempt from state and municipal taxes and can be exempt from federal taxes if used for certain higher education expenses.
What are I Bonds?
I bonds, or Series I Savings Bonds as they’re officially known, are government bonds that were created to protect investors’ money from inflation by partially tying the interest rate to inflation. Since these bonds are backed by the U.S. government, they’re considered a relatively safe investment. Once purchased, these bonds have a 30-year final maturity period – an original 20-year maturity period followed by a 10-year extended maturity period. There are two minimum time requirements to keep in mind with I bonds: First, you must wait at least one year from the issue date to cash them out, meaning your money is locked away for that time. There are very limited exceptions, such as being affected by a natural disaster, that allow you to cash the bond within the first year after purchase. Second, if you cash your I bond within the first five years after purchase, the previous three months of interest are taken off the bond’s value. We’ll talk about this more in a minute.
How do I Bonds Earn Interest?
Like other bonds and securities, I bonds earn interest and provide a return on investment for the person named on the bond. However, interest on I bonds is unique and a bit confusing, so let’s break it down together.
"Three" Interest Rates
When learning about I bonds, you will hear about three different interest rates. They are a:
Fixed interest rate — The fixed rate on an I bond is set when you buy the bond and stays the same for the bond’s life.
Variable interest rate — The variable rate on an I bond is adjusted every six months and is tied to inflation.
Composite interest rate —The composite rate is created from a complex formula involving the fixed and the variable rate.
While the fixed and variable rates are important, the composite interest rate is the one that directly affects the amount of money the I bond is earning. For bonds issued between May 1, 2023, and October 31, 2023, the composite rate is 4.30%. Do you currently have I bonds? If so, you can use Treasury Direct’s calculator to find the current value of your bond. Please note that this calculator cannot predict the future value of an I bond because future inflation rates cannot be predicted.
Interest Can't be Negative
As we all know, inflation rates change over time. It’s possible for inflation to be negative, which can cause the variable rate on I bonds to become negative.
However, the Treasury Department has set a floor of 0% for all I bonds, meaning the composite interest rate will never be negative and the bond’s redemption value won’t drop during periods of deflation, rather it will remain consistent because the interest rate is 0%.
Adjusting Interest Rates
Interest rates for I bonds are adjusted by the Treasury Department in May and November. If the fixed rate is adjusted, it only affects new purchasers. If you already own an I bond, your fixed rate isn’t affected. If the variable rate is adjusted, it affects current I bonds and newly purchased bonds. The impact on current I bonds depends on the purchase month. To understand when your interest rate will change, visit this chart from Treasury Direct.
Semiannual Compounding Interest
I bonds earn interest every month, and it is compounded semiannually. Put simply, this means that twice a year the interest your bond has earned in the past six months is added to the principal amount and then interest is earned on that new value. Like the variable interest rate, interest is added to your bond in the same months that your composite interest rate changes; the month you bought it and six months later.
Three-Month Interest Penalty
Remember those minimum time requirements we mentioned earlier? In addition to waiting one year before you can cash your bonds out, if you cash them out within the first five years, you give up the last three months of interest. (We know, penalties aren’t fun, but these are the rules!) The good news is when you check the value of your bond during the first five years, Treasury Direct automatically deducts this three-month penalty from the value. That means you see the amount you would receive if you cashed the bond out that day.
Do I Have to Pay Taxes on I Bond Interest?
We have a little more good news— interest earned on I bonds isn’t (usually) subject to local or state taxes! That said, if you get the bonds as part of an inheritance or estate, you might have to pay inheritance and/or estate taxes.
The less good news is that you do have to pay federal taxes on I bond interest. Federal taxes on I bonds can be paid each year, when the bond matures, or when the bond is cashed. That said, if the interest is used to pay for qualified higher education expenses, it can be completely tax free.
How Can I Purchase I Bonds?
After doing your research, you can buy I bonds online through TreasuryDirect.gov. The site has a guided tour to help you open an account. You will need to have a few things ready, including:
Your tax ID number (SSN or EIN)
Your email address
Your bank account and routing number
Through this account you can buy electronic I bonds, as well as other bonds.
I Bond Purchase Limits
You can buy I bonds for as little as $25. But, as with all good things, there are limits on how many you can buy. As of December 2022, the current bond purchase limits are as follows:
$10,000 in electronic I bonds
$5,000 in paper I bonds that can ONLY be bought with a federal tax refund
Purchase limits on I bonds apply to the person named on the bond, not who bought the bond. For example, you could buy $10,000 in I bonds in your name and another $10,000 in I bonds in your child’s name.
How Do I Cash I Bonds?
Do you already have I bonds and want to cash them? TreasuryDirect has the exact steps for cashing out your I bonds available. Here’s a quick summary of the cash out process.
Electronic I bonds can be cashed online in any amount of $25 or more to the penny. This means you don’t have to withdraw the bond’s entire value at once, but you must leave at least $25 in your account if you choose to cash only part of the bond. Additionally, if you withdraw part of the bond’s value, you will only receive interest on the portion you withdraw.
Cashing paper I bonds works a little differently. Unlike electronic bonds, you must redeem the full value of the paper I bond at one time. This can be done at a bank or through the Treasury Department.
Be sure to check with your bank about their limits for cashing bonds and what identification you need to bring with you. If you choose to cash the bond through the Treasury Department, you’ll need to fill out a form and mail it in.
Don’t forget, regardless of where you go to cash your I bond, if you’re doing so less than five years after the bond was purchased, you forfeit the last three months of interest. You will also be responsible for federal taxes on the interest you receive from the bond.
Are I Bonds for You?
After reading all of this, perhaps I bonds seem appealing. But, of course, as with any investment, they require careful consideration, and you need to evaluate if the risk fits with your unique financial situation.
As discussed above, the interest rates on I bonds tend to be higher than other bonds or savings options, such as certificates of deposit. I bonds also have several benefits.
Firstly, like other government bonds, I bonds are backed by the U.S. Treasury, meaning the risk of default is minimal – AKA a pretty safe investment. Additionally, they aren’t subject to state or local taxes. And, if used for certain higher education expenses, they’re also exempt from federal taxes.
The main drawback to I bonds is the maturity requirement. Since I bonds cannot be cashed until at least a year after purchase, your money is locked away for that time. I bonds may not be the best investment choice for you if you think you might need that money in the next 12 months.
Many consider I bonds to be an intermediate investment strategy, a way to grow your money if you’re planning on a large purchase, such as the down payment on a house or renovating your master bath in five to ten years. By waiting until the five-year mark passes, you can take advantage of the interest earned without paying the three-month penalty.
I bonds can be a good investment strategy if you’re looking for a higher interest rate and don’t mind waiting at least five years to cash them out to avoid the three-month penalty.
Unlike other bonds, it’s difficult to predict the future interest rates on I bonds due to the variability in inflation. However, since historical rates have almost always been positive, they are a popular option for growing money.
Another thing to keep in mind is that inflation has risen sharply since the pandemic began in 2020. While economists agree that inflation is likely to slow down in 2023, they aren’t predicting deflation, meaning I bonds will likely continue having a positive rate of return.