If there is a positive aspect for investors during these inflationary times, it just could be the old standby gifts of grandparents to newborns: U.S. Savings Bonds. More precisely, the Series I savings bonds, so called because the interest it pays is tied to inflation, which is now at its highest point in 40 years.
Series I Bonds now pay 9.62% interest through the end of October 2022 and will be reset in November, which far surpasses other current options for cash reserves. In addition to protecting your purchasing power, Series I Bonds also offer the safety of government backing, unlike corporate bonds and equities.
This looks like a good opportunity, especially given increasing inflation and recent stock market volatility, which saw the S&P 500 plummet by more than 20% since January, capping its worst six-month start to a year since 1970. But there are some considerations that should be weighed before buying.
As with any investment, you should calculate how buying Series I Bonds will affect your overall asset allocation, especially over the long term. For instance, switching from a 60% equity/40% fixed-income portfolio to 55% equity/45% fixed income (Series I Bonds are considered fixed) may have a significant impact on your retirement plan.
But before we get too deep into these considerations, let us look at some background on Series I Savings Bonds.
Background on Series I Bonds
Interest rates on I Bonds are set twice a year – in May and November – and comprise two components. The first is a fixed rate that applies for the life of the bond (the current rate is 0%). The second is a variable rate that changes every six months and is based on the Consumer Price Index, which is the rate of inflation.
This means that you are not locked in on the current rate paid when you purchase the bond. New rates take effect every six months from the issue date of the bonds. If inflation continues to increase, a higher interest rate would be paid on the six-month anniversary. Conversely, if the Federal Reserve (Fed) is successful in taming inflation, future rates paid on your bond will drop.
Two ways to purchase I Bonds
The first is in electronic form through TreasuryDirect. That requires you to set up a TreasuryDirect account if you don’t have one already. Electronic I Bonds come in any amount of $25 or more. For example, you could buy a $101.34 bond. There is a limit of $10,000 per calendar year for individuals with a Social Security number or entities with an employer identification number (EIN) with the opportunity for gifting to others. A family of four can acquire $40,000 of I Bonds per year electronically as long everyone uses their own Social Security numbers.
The other method of acquiring I Bonds is by paper form using your federal tax refund. That allows you to purchase an additional $5,000 above the $10,000 electronic annual limit. Paper bonds are available in $50, $100, $200, $500 or $1,000 denominations.
Cashing in bonds
Among the limitations of I Bonds are their redemption features. An I Bond cannot be cashed in for at least 12 months, so if you are going to acquire I Bonds, make sure that you will not need those funds for at least a year. In addition, if a bond is cashed in before it is five years old, you will lose the last three months of interest as a penalty.
Electronic bonds are redeemed through TreasuryDirect while paper bonds are sent to Treasury Retail Securities Services along with Form 1522. Also, some financial institutions will cash paper bonds for their customers.
There are a few intricacies to how interest is taxed on I Bond. Generally, they are subject to federal tax but not state or local tax. You have a choice to defer reporting the interest income until you cash in the bond, change ownership of the bond (such as gifting to a child or a charity), or the bond reaches maturity. Alternatively, you can choose to report interest annually as it is earned, which may be advantageous if the owner is in a lower tax bracket than they expect to be in when the bond matures (such as a child).
There is an opportunity to avoid taxation entirely if the taxpayer pays qualified higher education expenses at an eligible institution, but there are limitations. The bonds have to be cashed in the same year that the higher education expenses occurred for either yourself, your spouse or your dependents. You also have to have been at least 24 years old before the bonds were issued, which generally limits them to bonds owned by parents. And you cannot be married and filing separately.
In addition, the tax benefits begin to get phased out if your modified gross income is above $85,800 single ($128,650 married filing jointly). They are completely phased out at $100,800 single ($158,650 married filing jointly).
One final note on taxation: If someone passes away owning I Bonds with deferred interest, the executor usually determines whether the interest is reported on the deceased’s final income tax return or by the beneficiary. Also, bonds inherited through a death do not count against the annual limits.
While the current interest rate on I Bonds is certainly enticing, consider the implications of purchasing them:
- They should fit in your overall investment plan, and unless you are purchasing significant amounts (such as gifts for family members) the annual limit may not allow enough to be purchased to move the needle of your overall portfolio.
- The rate is tied to inflation, so if the Fed is successful in taming inflation, the bonds you purchase now may be paying a lower rate in just a few years because the rate is recalculated every six months.
- They are backed by the federal government, making them a safe investment, but you cannot sell them to another individual and need to hold them for at least one year before they can be cashed in. Even then, you may be subject to a three-month interest penalty if you cash the bonds before they are 5 years old.
Finally, if you still have questions, consult your advisor to strategize how to incorporate Series I savings bonds into your overall financial plan.
Paul Kieffer CPA/PFS, CFP ®, CLU, CGMA, is Senior Vice President, Regional Planning Strategist for Key Private Bank. He can be reached at (716) 819-5581 or [email protected].
Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice. KeyBank is Member FDIC. KeyCorp. © 2022. CFMA #221003-1749592
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