2022 has started out as a very difficult year for most Americans. The stock market is down while inflation is up and wages have shown signs of stagnation. This combination has put a strain on the purchasing power of people across the country.
In this environment, I-Bonds, with their promise of inflation-matching returns, look like a promising island of stability and value protection in an otherwise very stormy situation. In reality, while these numbers look promising, the details behind them make I-Bonds a less ideal investment than they appear on the surface. That’s not to say they’re a bad use of your money, just one where the actual reality may not live up to the title’s promise in most scenarios.
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Some key limitations of I-Bonds
First, each person is limited to $10,000 in direct purchases of I-Bonds per year, plus an additional $5,000 if purchased through a tax refund. This limitation means that while I-Bonds can play a role in your financial plan, you shouldn’t expect them to be able to be used to protect against inflation for truly life-changing amounts of your money.
Plus, once you buy an I-Bond, your money is locked in for at least a year, unless you live in a declared disaster area. It is therefore important to have an alternative source of emergency money for at least the first year after purchasing an I-Bond. Otherwise, if you have an unexpected need to tap into your money sooner, you might find that the interest you pay to borrow while waiting for that timer to appear exceeds what you earn on the I-Bond.
As if that weren’t enough, if you cash in your I-Bonds before you’ve held them for five years, you’ll lose the last three months of interest. In other words, to really get the promised inflation-matching returns from I-Bonds, you need to hold onto your I-Bonds for at least five years. Any shorter holding period means you will get less than this overall figure. It’s important to realize this because a five-year time horizon is about when it starts to make sense to invest in stocks to try to to beat inflation.
Then, of course, there are taxes. Although exempt from state taxes, the money you earn on I-Bonds is taxed as ordinary interest income at the federal level. As a result, your overall returns may keep up with inflation, but your buying power over that money probably won’t.
Put it all together, and I-Bonds become tools that have some utility, but aren’t necessarily a great alternative for all other uses of cash or bonds.
So where do I-Bonds make sense?
I-Bonds can be a useful tool when transferring money from stocks to cash or bonds a few years before your children start college. Indeed, you can often exempt the interest on I-Bonds from your income for tax purposes if you use the money to pay eligible educational expenses.
Additionally, 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 tax on interest received on an I-Bond until you sell it, resulting in less annual internal drag on your returns than with standard bonds. Be aware, however, that the interest on I-Bonds adjusts every six months, so if inflation comes back under control, the current rate of return you get on your I-Bonds will decrease.
Finally, if you’re saving for a goal more than a year away and would otherwise save in a checking or savings account, I-Bonds could 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 likely have bigger problems on our hands than just the missing money.
If you’re considering using I-Bonds, get started 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 the clock starts ticking. So if you’re considering using I-Bonds, now is the perfect time to put your plan in place to incorporate them into your overall portfolio.
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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.