Should You Buy I Bonds Now? | Smart Change: Personal Finance

(Chuck Saletta)

2022 has started as a very difficult year for most Americans. The stock market is falling while inflation is rising and wages are showing signs of stagnation. That combination has strained the purchasing power of people across the country.

In that environment, I-Bonds look like a promising island of stability and value protection in an otherwise very stormy environment, with their promise of inflation-matched returns. In reality, while those headline numbers look promising, the details behind them make I-Bonds a less ideal investment than they seem at first glance. That’s not to say they’re a bad spend of your money, just one where the actual reality doesn’t live up to its main promise in most scenarios.

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Some Important Limitations of I-Bonds

First, each person is limited to $10,000 in direct I-Bonds purchases per year, plus an additional $5,000 if purchased through a tax refund. That limitation means that while I-Bonds can play a role in your financial plan, you shouldn’t expect them to be able to use them to protect truly life-changing amounts of your money from inflation.

In addition, once you buy an I-Bond, your money is secured for a minimum of one year, unless you happen to live in a declared disaster area. That makes it important to have an alternative source of emergency money for at least the first year after purchasing an I-Bond. Otherwise, if you unexpectedly need to withdraw your money early, you might find that the interest you pay to borrow while you wait for that timer to expire is higher than what you earn on the I-Bond.

As if that weren’t enough, if you cash out your I-Bonds before holding them for five years, you’ll lose interest for the last three months. In other words, to really get the promised returns from I-Bonds, you need to hold your I-Bonds for at least five years. Any shorter retention period means you get less than that header number. This is important to realize, as a five-year time horizon is around the time when it makes sense to invest in stocks as a means of trying defeat inflation.

Then, of course, there are the taxes. Although exempt from state taxes, the money you earn on I-Bonds is taxed at the federal level as ordinary interest income. As a result, your headline returns can keep up with inflation, but your purchasing power on that money probably can’t.

Put it all together and I-Bonds become tools that have some use, but aren’t necessarily a great alternative to all other cash or bond uses.

So where do I-Bonds make sense?

I-Bonds can be a useful tool if you’re shifting money from stocks to cash or bonds a few years before your kids start college. This is because you can often exempt the interest on I-Bonds from your income for tax purposes if you use the money to pay for qualified education expenses.

In addition, I-Bonds can be useful in a bond ladder, especially if you have a time horizon of at least five years. This is because you can defer the tax on the interest received on an I-Bond until you sell it, resulting in less annual internal drag on your returns than with standard bonds. Keep in mind, though, that I-Bonds interest rates adjust every six months, so if inflation comes back under control, the current yield you’re getting on your I-Bonds will shrink.

Finally, if you’re saving for a goal that’s been over a year and you’d otherwise be saving in a checking or savings account, I-Bonds can give you a better risk-adjusted return on your money. Remember that I-Bonds are securities offered by the US Treasury. If the US government stops paying its bondholders, we’ll probably have bigger problems than just the missing money.

If you are going to use I-Bonds, start now

Ultimately, I-Bonds can serve a reasonable purpose as part of your overall financial plan. The one-year minimum holding period means the sooner you buy them, the sooner that clock starts ticking. So if you plan to use I-Bonds, now is a good time to make your plan to make them part of your overall portfolio.

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Chuck Saletta has no position in any of the listed stocks. The Motley Fool has no position in any of the listed stocks. The Motley Fool has a disclosure policy.

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