Are you looking for a way to fight inflation in your investment portfolio? Inflation rates have been hitting highs not seen since 2007 and purchasing power is a big concern for Americans. Savings accounts and bank CDs are generally yielding somewhere between zero and 0.5% annually, which has also left many wondering where to invest their money.
The U.S. Department of the Treasury is now paying a 7.12% annual rate on I bonds. Is that for real? In this blog, we are going to explain why several investors are looking into I bonds and we will give you our honest opinion on this investment strategy.
What are I Bonds?
I bonds are savings bonds issued by the federal government. They are designed to protect the value of your money from inflation. The “I” stands for inflation. The interest rate on I bonds is directly correlated with inflation. If inflation is high, the interest rate is high. If inflation is low, the rate is low. Inflation is quite high right now. It hit 6.22% in October which is well above the 1% or 2% inflation that we’ve been used to.
How are I Bonds interest calculated?
I Bonds interest rate is a combination of two rates which is called the composite interest rate. It is calculated based on a fixed interest rate and an inflation-adjusted rate. The interest structure is what makes I Bonds quite unique.
The composite interest rate is a complex formula: Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]
- The fixed interest rate is set at purchase and lasts 30 years. This is currently set at 0%.
- The inflation adjusted-interest rate is calculated twice a year which is usually May 1 and November 1.
When you go to the Series I Bonds, it will say you’ll get 7.12% interest rate from now until April 2022.
Do I Bonds earn interest monthly?
Yes, I Bonds earn interest monthly. However, you only get access to those interest payments when you cash out the bonds. The interest you earn is added to the value of the bond twice per year (May and November).
Is the current inflation interest rate on I Bonds 7.12%?
Yes, 7.12% is the current inflation interest rate if you purchase the I Bonds before May 1, 2022. The reason the inflation interest rate is so high is because inflation has been quite high for the past months. This also means that the composite rate is also an annualized 7.12% for the first six months that the bond is held. This is the highest that it’s been since May 2000.
Are I bonds taxed?
I bonds are subject to federal income taxes but they are exempt from state and local income taxes. This makes them even more attractive to those who live in high-tax states and cities. They can sometimes be fully tax-exempt if they are used to pay for qualified higher education.
You can choose to pay taxes on the interest earned when the I bonds are cashed. If you cash out any I Bonds in a specific year, then Treasury Direct will generate a 1099 tax form for the accumulated interest.
The owner is responsible to pay for the taxes. This means that if you were gifted an I Bond, then you are required to pay the tax owed.
Are I bonds a good investment?
I’ll give you 4 reasons why I bonds might be a good investment and 4 reasons why you should think twice.
4 reasons why they might be good investments:
- I bonds are a great inflation hedge. Whenever inflation is up then the rate is up.
- 3% to 5% potential return for an investment guaranteed by the federal government is pretty good. Think about what you’re earning in cash right now, 0.50% if you use a high yield savings account.
- I Bonds are exempt from state and local taxes but you do have to pay federal taxes. They may also be entirely tax-exempt if they are used to pay for qualified higher education. It can be an attractive college savings strategy as an alternative or in addition to a 529 plan.
- Their value can never go below zero.
4 caveats you need to know before buying I bonds:
- There is a lack of flexibility because you will be locked-in for 1 year. You cannot withdraw for the next 12 months and even if you do withdraw after 12 months (but before five years), you will forfeit three months worth of interest.
- If inflation drops, then your return will drop.
- The maximum purchase of digital I Bonds is $10,000 per person. You can also use your federal income tax refund to purchase an additional $5,000 in paper I Bonds. You will need to think about if that’s worth your time.
- If you have excess cash, can you make more money investing in stocks?
To find out more about I Bonds, visit District Capital Management.
