(Chuck Saletta)
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. That combination has tested the purchasing power of people across the country.
In that environment, I-Bonds, with their promise of inflation-equivalent returns, seem like a promising island of stability and protection of values in a situation that is otherwise very stormy. In reality, while those headline numbers look promising, the details behind them make I-Bonds a less than 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 main promise in most scenarios.
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Some key limitations of I-Bonds
First, each person is limited to $10,000 of direct purchases of I-Bonds per year, plus an additional $5,000 if purchased through a tax refund. That limitation means that while I-Bonds can play a role in your financial plan, you shouldn’t expect that they can be used to protect life-changing amounts of your money from inflation.
Also, once you buy an I-Bond, your money is tied up for at least a year, unless you live in a declared disaster area. That makes it important to have an alternate source of emergency money for at least the first year after purchasing an I-Bond. Otherwise, if you have an unexpected need to use your cash early, it’s possible that the interest you’re paying on the loan while you wait for the timer to go off may exceed what you’re earning on the I-Bond.
As if that wasn’t enough, if you cash in your I-Bonds before you’ve had them for five years, you’ll lose interest for the most recent three months. In other words, to really get the promised inflation-matching returns on I-Bonds, you need to hold your I-Bonds for at least five years. Any shorter holding period means you will get less than that main number. It is important to realize this, since a five-year time horizon is when it starts to make sense to invest in stocks as a means to try defeat inflation.
Then, of course, there are the 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 purchasing power over that money probably won’t.
Put it all together, and I-Bonds become tools that have some use, but aren’t necessarily a great alternative to all other uses of cash or bonds.
So where do I-Bonds make sense?
I-Bonds can be a helpful tool when you’re trading money from stocks to cash or bonds a few years before your kids start college. That’s because you can often exempt the interest on I-Bonds from your income for tax purposes if you’re using the money to pay for qualified educational expenses.
Also, I-Bonds can be useful in a link ladder, especially if you have a time horizon of at least five years. That’s because you can defer tax on interest received on an I-Bond until you sell it, creating less annual internal drag on your returns than with standard bonds. Keep in mind, however, that the interest on the I Bonds adjusts every six months, so if inflation is back under control, the current rate of return you are earning on your I-Bonds will be reduced.
Finally, if you’re saving for a goal more than a year out and would otherwise be saving in a checking or savings account, I-Bonds may offer you a better risk-adjusted return on your money. Remember that I-Bonds are securities offered by the United States Treasury. If the US government stops paying its bondholders, we probably have bigger problems on our hands than just missing money.
If you are going to use I-Bonds, start 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 watch will start ticking. So if you plan on using I-Bonds, now is a great time to put your plan in motion to make them part of your overall portfolio.
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mandrel saletta has no position in any of the mentioned stocks. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.