What are I Bonds good for?

Posted by Frank Napolitano on October 27, 2016

In my previous post, I described what an I Bond is. Here I will offer a few examples of how I Bonds might make sense in an investment portfolio.

Recall that I Bonds are a sort of inflation-protected savings account. They earn interest every year equal to inflation plus a (currently small) fixed rate. The interest accrues tax-deferred until you sell your bonds or they mature in 30 years, whichever comes first. The unique characteristics of I Bonds can make them a good investment in a number of different situations.

An emergency fund

The most obvious situation (to me at least) where I Bonds make sense is as an emergency fund. Full disclosure: my wife and I have been buying these kinds of bonds for several years in our emergency fund.

I Bonds are guaranteed to keep their value over time because of their inflation-protection. For example, $20,000 in I Bonds purchased today will be worth $20,000 five years from now in today’s dollars, i.e., they will have kept pace with inflation. They will be worth $20,000 in today’s dollars ten years from now.  And so on. Simply put, they are guaranteed to maintain their purchasing power over time. Funds in a traditional CD or savings account may not because rates vary over time. In some years they will be higher than inflation, in others not. If one of your goals with your emergency fund is to maintain your purchasing power, I Bonds are a great option.

Another reason I like I Bonds for an emergency fund is that because you have to purchase them in a treasury direct account, your emergency fund is automatically segregated from the rest of your cash accounts. Accessing your account is necessarily more difficult than simply going to the ATM. So if you’ve ever been tempted to take money out of savings for a non-savings purpose, having your emergency fund at treasury direct might help.

Finally, since you may rarely (perhaps never) use your emergency fund, the tax-deferral of I Bonds’ interest may be a big benefit. Unlike a CD or savings account, whose interest is included every year in your taxable income, the interest on I Bonds is tax deferred until you sell the bonds or they mature. If you do not sell them until retirement, you may be able to defer paying interest until you are in a lower tax bracket. This opportunity to transfer interest into a future, lower-tax period makes I Bonds attractive for an emergency fund.

Additional retirement savings

Depending on your situation, I Bonds might make sense for your retirement portfolio. After you’ve funded other tax-advantaged savings accounts such as an IRA or employer retirement account, you could divert additional savings to I Bonds. I Bonds offer tax deferred growth that is similar to that of a traditional IRA, but remember, you do not get any tax deduction for purchasing I Bonds.

Whether to purchase I Bonds as part of your retirement savings plan is very particular and depends on a number of factors, including your asset allocation, account structure, and income tax situation. If you currently save for retirement outside of dedicated retirement accounts, talk to your advisor about whether I Bonds might make sense for you.

Paying for college

In certain circumstances, taxpayers can exclude the interest earned on I Bonds that have been redeemed to pay for qualified higher education expenses. The main drawback to this strategy is the income limitation that prevents the deduction for individuals or couples earning above a certain amount. In 2016, the income limit begins at a modified adjusted gross income of $77,200 for single filers and $115,751 for joint filers.

529 plans will almost always be a better option for college savings. The account grows tax deferred, like I Bonds, but importantly there is no income limitation when money is taken out to pay for qualified education expenses.

However, if you (or someone you know) already owns I Bonds and you fall under the income threshold, you might consider redeeming those bonds to pay for higher education costs. More details are available at the Treasury’s website here.