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Series I savings bonds have gone from a relatively unknown savings bond option to one of the most talked about in the personal finance community.
The increase in series I savings bond sales is primarily due to one factor, an interest rate of nearly 10%, with minimal risk.
The interest rate of series I savings bonds is tied to inflation.
Therefore, when inflation is high, so is the short-term interest rate on series I savings bonds.
According to data released by the Treasury Department, the Treasury sold $979 million of series I savings bonds before the deadline on Friday, October 28, 2022.
This is almost as much as it sold in three years from 2018 to 2020, when buyers purchased just over $1 billion.
Though a nearly 10% return on savings bonds is appealing, there are also downsides. We’ll cover those below.
By the end of this article, you should have a better understanding of the pros and cons of investing in series I savings bonds.
The Pros And Cons Of I Bonds
What Are Series I Savings Bonds
Series I savings bonds are a specific kind of U.S. savings bond created to shield your money’s value against inflation.
With inflation at four-decade highs, investors increasingly seek higher-yielding, lower-risk investments, and I-Bonds fit the bill.
The Treasury determines the inflation rate for the subsequent six months twice a year.
I-Bonds are currently at a 6.89% interest rate and will remain that way through April 2023.
This is a decrease from the 9.62% interest rate in the six months leading up to October 2022.
I-Bonds expire after a 20-year initial holding term, but investors can extend the maturity by ten years.
That implies that I-Bonds can continue to earn interest for 30 years or until you redeem the bond, whichever comes first.
The Treasury automatically redeems after 30 years.
Pros of Series I Savings Bonds
#1. Inflation Protection
Compared to most other saving strategies, series I savings bonds offer far better protection against inflation.
That is because the interest rate will continue to be adjusted every six months based on the expected inflation rate.
Therefore, the return on I-Bonds will always be close to the current inflation rate.
A well-rounded investment portfolio typically includes a mix of stocks, bonds, and real estate.
Bonds yield a lower return than stocks but have less risk.
If inflation remains low, this would result in a lower interest rate over the long haul.
If inflation skyrockets, it’s better to have some protection.
#2. Safe Investment
The U.S. government backs series I savings bonds.
Therefore, if the U.S. government keeps honoring its debt, there’s no chance of default.
If I-Bonds were to default, we would have more pressing issues than our funds.
The results appear when comparing I-Bonds’ risk and return to other bonds.
#3. Exempt From State And Local Tax
I-Bonds are not subject to state income taxes but are liable to federal income tax when cashed in.
Additionally, investors may occasionally be tax-free if they use I-Bonds for education.
Therefore, I-Bonds are tax efficient.
However, federal tax is at the ordinary income rate, not the capital gains rate.
So while there are excellent tax benefits for state and local taxes, federal taxes may be higher than other investments depending on your tax bracket.
That said, you can still benefit from not having to pay state and local taxes on the interest from I-Bonds.
Make sure you pay close attention to these details on your tax return.
Cons of Series I Savings Bonds
#1. Early Withdrawal Penalties
You must own series I savings bonds for an entire year before you can use your money again.
If you want to use this money as your emergency fund, this could be an issue because you usually want to access your emergency fund immediately.
One method is to put more money in your emergency fund than you would need for the next year.
This way, you do not rely on using I-Bonds as a portion of your emergency reserve.
There is also a penalty of three months’ interest for withdrawing funds within five years.
An interest penalty of three months may sound harsh, but it’s not as bad as it sounds.
As long as I-Bonds provide a higher return than other government securities, you’ll likely make more interest even with the early withdrawal penalty.
Regardless, before investing in I-Bonds, you should be sure you will only need to use the money a year after purchasing.
#2. Unpredictable Interest Rate
The variable interest rate on I-Bonds is both a pro and a con.
When inflation is high, you can enjoy a much higher interest rate that keeps up with inflation.
However, the rate can decrease significantly when the rate resets every six months.
We’re already seeing this take place with the interest rate decrease of nearly three percent starting in November 2022.
If inflation returns to two percent or lower, like in the past decade, the interest rate on I-Bonds will also continue to decrease.
While the interest rate on I-Bonds is more unpredictable than many other bonds, other securities, such as stocks, likely see even more variability in returns.
With I-Bonds, at least you know that you won’t lose money on your investments unless there is a default situation.
Individual stocks can even go to zero quickly if something happens to the company.
#3. Maximum Annual Investment
There are limitations on the amount of I-Bonds you can purchase in a calendar year.
Anyone with a social security number can buy up to $10,000 in I-Bonds annually.
Additionally, you can purchase up to $5,000 in I-Bonds with your tax return for a total of $15,000.
Some people might never dream of putting $10,000-$15,000 annually into an I-Bond, but for others with large portfolios, this limit may hinder them from wanting to invest in a new bond.
If your household has multiple members, you can open up separate accounts and invest the same for every individual.
Therefore, a family of four could invest $40,000 to $60,000 (with tax returns) in I-Bonds in a calendar year if they take all the necessary steps.
If you think this sounds like a hassle, you’re probably right. But some are motivated to jump through all these hoops for a higher return with low risk.
#4. Limited Purchasing Options
Investors can’t purchase I-Bonds through brokerage accounts such as Vanguard or Fidelity.
And long gone are the days when you could purchase paper bonds.
Investors can only purchase Series I savings bonds directly from the Treasury Direct website.
Therefore, you would need to keep your investments in a separate account from other investments.
The Treasury Direct website is quick and does the job, but it is a pain to sign up for a separate account and then keep tabs on your investments in a different place.
Should You Purchase Series I Savings Bonds
The decision to purchase series I savings bonds is a personal decision.
You should research or consult a financial professional before making any decisions.
That said, there could be a place for series I savings bonds in your portfolio, especially while interest rates are high.
We are using I-Bonds to build up an emergency savings fund.
As noted earlier, you need to be careful if you go this route because the funds will not be available during the first year after purchase.
Then there is a minor penalty of losing three months of interest if you cash out before year five.
However, if you have the runway to let your funds sit for a year, you could have emergency savings growing at a higher rate of return than a savings account.
There could be a benefit to putting a small amount of your net worth in I-Bonds.
Investing in I-Bonds will allow you to hedge a part of your portfolio against inflation risk.
The downsides are the unpredictable future interest rates, limitations on how much you can purchase, and you can only purchase through Treasury Direct.
If you can live with these downsides, finding a near-guaranteed return on investment at the same interest rate will be challenging during times of high inflation.
This article originally appeared on Wealth of Geeks.