I Bond Manifesto: Why inflation-linked savings bonds can work as part of your emergency fund

Sept. 26, 2021

It’s no secret that I’m a huge fan of U.S. Series I Savings Bonds, a simple, very safe investment that can accurately track — or exceed — official U.S. inflation without risking a dime. I’ve been pounding the table for I Bonds for a decade.

Over the next 12 months, I Bonds look likely to provide a yield of 5.0% (or more), about 10 times the return of best-in-nation insured savings accounts. (Nov. 1 update: I Bond’s inflation-adjusted rate soars to 7.12%, annualized, for six months)

And now, Professor Zvi Bodie, a long-time advocate of inflation-protected investments, is on a mission: To persuade the Consumer Financial Protection Bureau to include I Bonds in its list of recommended investments for an investor’s “emergency fund,” a safe place to store cash for unexpected needs, like a job loss. He recruited me — along with inflation watchers Mel Lindauer and Michael Ashton — to help advance the cause. The result was this:

The I Bond Manifesto

Financial planners and investment advisors all tell you to create an emergency fund before you start investing in risky assets. Your emergency fund should be held in safe and liquid assets like FDIC-insured saving accounts. But interest rates on these accounts are close to zero and taxable. Moreover, if these accounts are retirement accounts such as an IRA, withdrawals before age 59 1⁄2 are subject to a 10% penalty in addition to taxes on the withdrawals.

So where should people invest their emergency funds? We say they should consider U.S. Treasury Series I Saving Bonds, commonly called I Bonds.

Background on I Bonds

First introduced in September 1998, I Bonds (the “I” stand for “Inflation”) are inflation-protected, are issued by the United States Treasury, and provide a guaranteed real rate of return for 30 years. This is in contrast to the nominal fixed rate of interest provided by most traditional bonds and CDs. The total yield of an I Bond is made up of two components: a fixed rate that remains the same for the 30-year life of the bond, and an inflation adjustment that’s reset every six months. The fixed rate is currently zero, and the last inflation adjustment in May 2021 was 3.54% per year. You add these two components together to arrive at the composite rate of 3.54% per year.

I Bonds were designed primarily for small savers/investors. You can buy a maximum of $10,000 of I Bonds a year for each Social Security number via TreasuryDirect. In addition you can buy them with any federal tax refund due to you, up to $5,000, for which you will receive paper I Bonds. You cannot hold them in a special retirement account, but the taxes due are deferred until maturity or the date they are redeemed. (Editor’s note: I Bonds must be held 12 months before you can redeem them.) If you redeem I Bonds prior to five years, you’ll lose the last three months’ interest. After holding them for five years, there is no penalty for redeeming I Bonds before maturity, except that the federal tax on the interest must be paid in the same year as the redemption.

I Bonds offer many benefits:

  1. They’re risk-free. They are obligations of the U.S. Treasury, so they are even more secure than Social Security benefits. (It is possible for the U.S. Treasury to default on these bonds, so strictly speaking they are not completely free of default risk as explained above.)
  2. They offer inflation protection. That’s especially important for retirees who no longer have wage increases to rely upon. With all the current government spending and deficits,inflation could return with a vengeance. I Bonds protect you against the ravages of future inflation.
  3. They’re tax-deferred. Even though you purchase I Bonds with after-tax money for your taxable account, they offer tax deferral for up to 30 years. You can elect to report the interest annually if you prefer, but most investors choose the default tax deferral option and thus only pay tax on the accumulated interest when they eventually redeem the I Bonds.
  4. They’re flexible. They offer a tax timing option. They can be redeemed any time between one and 30 years. That offers lots of flexibility after owning them for one year. This flexibility allows you to buy I Bonds when you’re in a high tax bracket and redeem them when you’re in a lower tax bracket, such as after you’ve retired or are temporarily out of work.
  5. They’re free from state and local taxation. This can mean higher after-tax returns for those investors who live in high-tax states, and they’re even better yet for folks who live in areas where they pay both state and local taxes.
  6. If used for qualifying educational expenses, the interest earned is free from federal taxes.
  7. They offer a put option. If future I Bonds offer a more attractive fixed rate, it may make economic sense to redeem the older lower-yielding I Bonds, pay the taxes due on the interest earned, and then buy the newer I Bonds with the higher fixed rate. (Remember, however, if you redeem I Bonds within the five years of purchase, you will forfeit the last three months of interest.)
  8. You can’t lose money. The composite rate can never go below 0%. I Bonds will never return less in nominal terms than you invested in them even if the country enters a prolonged period of deflation. You never lose the interest you’ve earned. In real terms you do better if there is deflation than if there is inflation. A recent bout of reported deflation took the I Bond composite yield to 0% for a six-month period. But as a result of the 0% “floor,” holders actually outstripped inflation by more than the guaranteed fixed rate during that period. So, if your I bond was worth $10,000 before that period of deflation, it would have been worth $10,000 after the deflation adjustment period ended. However, because of deflation, that $10,000 would buy more goods and services.

How I Bonds work

Now let’s explore the mechanics of purchasing and redeeming I Bonds and talk a bit about how they work. You must first open an individual account at TreasuryDirect.gov and link it to your bank account. Once your account is open, you can then make your purchases online and the Treasury will deduct the purchase price from your linked bank account.

Purchase limits. There is an annual purchase limit of $10,000 in I Bonds in electronic form per Social Security number. A married couple could, therefore, purchase a total of $20,000 per year.

A tax-time purchase option. The option to use your tax refund to buy up to $5,000 in paper I Bonds raises your limit from $10,000 to $15.000 in that year–$10,000 in electronic form and $5,000 in paper form.

Timing your purchases. Interest is earned on the last day of each month and is posted to your account on the first day of the following month. So, if you own your I Bonds on the last day of any month, you’ll earn that full month’s interest. Therefore, it’s best to buy your I Bonds near the end of the month, since you can earn a full month’s interest while only owning the I Bonds for perhaps a day or two. On the other hand, when redeeming I Bonds, you’ll want to do so on or near the first business day of the month, since redeeming them later in the month won’t earn you any additional interest.

Redeeming paper I Bonds. Simply take your paper I Bonds to your bank, sign the back and the bank will credit your account just as if you had deposited cash. The funds will normally be available to you the following day. You could also receive cash.

Redeeming electronic I Bonds. You can redeem your I Bonds (or any portion of your bond holdings, so long as you leave at least $25 in your account) using your online account. The money is then transferred into your linked bank account.

Avoiding probate. I Bonds don’t qualify for a step-up in cost basis at one’s death as many other investments, such as stocks and real estate, do. (I Bonds are like bank-CDs in that regard.) But you can title them in such a way as to avoid having them included in your estate subject to probate—by having either a second co-owner or a beneficiary listed on your I Bonds.

Signed by:

Zvi Bodie
zbodie@bu.edu, zvibodie.com
America’s Best Kept Investing Secret

Mel Lindauer
Founder and Former President, The John C. Bogle Center for Financial Literacy
and co-author The Bogleheads’ Guide to Investing, and The Bogleheads’ Guide to Retirement Planning

David Enna
Tipswatch.com

Michael Ashton, “The Inflation Guy”
EnduringInvestments.com Podcast: Cents and Sensibility

About Tipswatch

Author of Tipswatch.com blog, David Enna is a long-time journalist based in Charlotte, N.C. A past winner of two Society of American Business Editors and Writers awards, he has written on real estate and home finance, and was a founding editor of The Charlotte Observer's website.
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31 Responses to I Bond Manifesto: Why inflation-linked savings bonds can work as part of your emergency fund

  1. hoyawildcat says:

    I have a question about redeeming a portion of an I Bond after five years and therefore without any interest penalty.

    Say I want to RECEIVE $1000 in cash from a $10K bond that I purchased more than five years ago. On TreasuryDirect, would I request a $1000 redemption or would I need to calculate the principal that would, when added to the accrued interest, equal $1000? For example, say that the original $10K I Bond had grown during the five years to $13,000 (principal plus interest), i.e. a 30% increase. If I wanted $1000 in cash, would I redeem $1000, which is the amount of cash I want, or would I redeem $770, which, when added to the accrued interest (~$230), would equal ~$1000?

    • Tipswatch says:

      A redemption will include both principal and interest. If you redeem $1,000 it will be in both principal and interest, in proportion to your holdings in the I Bond. TreasuryDirect says: “Redemptions are comprised of principal and interest. (In a partial redemption, we pay interest only on the partial amount you cash.)”

      • hoyawildcat says:

        But that’s not my question. If I redeem $1000 will I get $1000 in cash, or will I get $1000 of the principal plus the accrued interest, which would be $1300 in cash?

        As TreasuryDirect says (and which I have read many times) “In a partial redemption, we pay interest only on the partial amount you cash.” That sounds to me like they’re going to give me my requested redemption ($1000) PLUS interest ($300), which would equal $1300.

        • Tipswatch says:

          My theory is if you are redeeming $1,000 you will receive $1,000 + plus the interest that $1,000 earned. I’ve never done this and I can’t find any reference to exactly what happens. But I am assuming TreasuryDirect will see the order as a withdrawal of principal. Give it a try and report back.

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  6. John Dragan says:

    If the CPI-U declines will that “change” result in a zero interest rate for the next 6 months?

    If I purchase an I bond at the current interest rate in January that interest rate expire in April when the new rate comes out or June?

    • Tipswatch says:

      If you purchase I Bonds in January, you will receive a full six months of 7.12% interest, annualized. Then the new variable rate will begin, based on non-seasonally adjusted U.S. inflation from September to March. That new rate isn’t likely to be 0.0%. After two months, with four months to go, it is already trending at 2.66%. You can track the monthly inflation numbers on this page: https://tipswatch.com/tracking-inflation-and-i-bonds/

      If you purchase anytime in January, the new variable rate will begin in July.

  7. Geraldine says:

    Such a helpful post, thank you David!! I bought my first I bonds ($10,000) last June after coming across your posts, and am a little confused re: the interest accrual. After their first 6 months, they show a balance of $10,088 on my account which seems too low given the 3.54% composite rate at the time of purchase. I’ve reached out to the Treasury help center, but so far, they’ve only given me a generic response. Am I misunderstanding something?

    • Tipswatch says:

      The $10,088 sounds right because TreasuryDirect won’t show you the three months interest you will forfeit if you redeem before 5 years. So you’ve actually earned $177 in interest, but minus three months is $88. TreasuryDirect notes: “When looking at changes in values for these bonds, rate changes will seem to be delayed by three months.”

      • Geraldine says:

        Thank you so much – makes total sense!!

      • JB says:

        Can you please clarify this? If 3.54 is the semi-annual composite rate, shouldn’t the 3 months of interest posted still be higher than what was being reflected in the above post? Based on your response, would the bond only be earning 354 annually if after 6 mos, it only earned $177? Thanks!

        • Tipswatch says:

          JB, I am not sure exactly what you are asking, but the penalty removes the “last three months of interest.” If you bought I Bonds last year, when the 3.54% rate was in effect, then you will get six months of 3.54%, annualized, and then 7.12% for six months. If you redeem after 12 months, you’d lose three months of 7.12%, or $178 on a $10,000 investment.

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  12. GVE says:

    David:
    I enjoy your posts. I have been investing in I Bonds up to the limit since 2015, and think they are a most excellent investment. I only wish that the annual limit were higher. (I have engineered my taxes most years to take advantage of the additional $5,000 opportunity.)

    One thing that you might want to cover in your blog is the ability/mechanics to convert paper bonds to electronic bonds. I found the process to be easy and like to have all of my bonds in one place electronically. (Apologies if you have already covered this subject recently and I missed it.)
    Regards.
    GVE

  13. Jeff Conrad says:

    In regard to item 7’s “put option”, can one reinvest all the proceeds from the redeemed bonds into new bonds or are you still subject to the $10K limit?

    Always learn from your posts. Thank you.

  14. BigDaddyRich says:

    We’ve been buying I-Bonds since 2012. I had to redeem several I-Bonds in 2020 to pay off a huge income tax bill, so I agree with this wholeheartedly. The Treasury Department should make it easier for people to open a TreasuryDirect account with just their Social Security number (or better yet, establish automatic TD accounts when a parent creates an S.S. # for their child or when someone turns 18).

  15. Allyn Perdue says:

    Superbly concise article which I’m sharing to FB shortly. Two comments follow:
    1) I didn’t see a reference to the one-year redemption restriction.
    2) TreasuryDirect has returned to requiring manual submission for linked accounts. One must print FS Form 5512 to take to the bank for signature and mail to the processing office in Minneapolis.

    • Tipswatch says:

      The manifesto did note: “They can be redeemed any time between one and 30 years.” But I added an “editor’s note” to this article to clarify that issue for people new to I Bonds.

  16. DW says:

    would be an ideal emergency fund option if the one year redemption restriction and <5 year penalty were reduced or eliminated

    • Tipswatch says:

      The idea, I think, is to build up a stockpile of I Bonds with various redemption periods. At any point after one year, those bonds are available to redeem if you need the cash. Otherwise, let them roll. One important tip: Always redeem I Bonds with the lowest fixed rate first.

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