Why inflation-linked savings bonds can work as part of your emergency fund
Nov. 1, 2022, update: Treasury sets I Bond’s new fixed rate at 0.4%; composite rate is now 6.89%
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:
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:
- 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.)
- 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.
- 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.
- 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.
- 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.
- If used for qualifying educational expenses, the interest earned can be free from federal taxes, within certain income limits.
- 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.)
- 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
Harry Sit
TheFinanceBuff.com
Robert Huebscher
CEO, Advisor Perspectives
Jim Sloan
Finance author, SeekingAlpha.com
Burton G. Malkiel
Economist and author of “A Random Walk Down Wall Street“
Robert Powell, CFP
CFP, Editor and Publisher, TheStreet’s Retirement Daily
Charles D. Ellis
Author of Winning the Loser’s Game
William F. Sharpe
Stanford University, professor of finance
Nobel Prize winner in economics
Robert C. Merton
Professor of Finance, MIT Sloan School
Nobel prize winner in economics
Treasury Inflation-Protected Securities 
Last October I was going to transfer my matured paper bonds online. I started the process on TreasuryDirect.gov and now have a manifesto with them listed out. I then realized how long it takes for them to transfer and would like to take them to the bank to be deposited. Can I still do that now that they are in the manifesto, or do I now need to continue the transfer process and mail it all in?
I am not sure about this, but it would seem like since you have not sent the savings bonds in, no transfer has taken place. It would be best to call TreasuryDirect to confirm this.
“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.”
The purchase limit is NOT “per Social Security number”. The purchase limit is per tax ID number. You, your spouse, your trust, your spouse’s trust, your business, your other trust, etc.
When I say “tax ID number” I mean “Social Security Number or Employer Identification Number”. These are the terms used on the Treasury Direct website.
On #7 you say you can redeem an older bond with a low fixed rate to purchase a current bond with a higher fixed rate. Would this count against your $10,000 annual limit?
Redeeming I Bonds has no effect on the purchase limit. You can still only purchase $10,000 per person per year.
I know the redemption would not count against the purchase limit, but if I redeemed to my Treasury Direct account and then used that money to buy a current I Bond, would that purchase count against the $10,000 annual limit. Thanks!
Yes, the purchase limit is not affected by an I Bond redemption. It remains $10,000 per person per year.
“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.” My question is whether more than one beneficiary can be listed or is it limited to just one beneficiary? Also, can a beneficiary designation be made at the account level (to apply to all I Bonds), or does it have to be done on a bond-by-bond basis?
You can create multiple owner designations in your Treasury Direct account. This can take the form of no beneficiary, such “OwnerFirstName OwnerLastName.” It can also take the form of a beneficiary, such as “OwnerFirstName OwnerLastName POD BeneficiaryFirstName BeneficiaryLastName” (i.e. “payable on death” ).
You assign an owner designation to each of the bonds you purchase in your Treasury Direct account. You can create new owner/beneficiary designations at any time, and you can also change the owner/beneficiary designation for existing bonds.
I do not believe you can have two beneficiaries on a single bond. You can have either no beneficiary or a single beneficiary per bond. In my case, I assign half the bonds to one beneficiary and half the bonds to another beneficiary.
Excellent overview of this savings bond type and a very worthwhile goal of convincing the Consumer Financial Protection Bureau to endorse I Bonds and educate the public about their use to build a cash reserve for emergencies through this product.
Shouldn’t the six month compounding of interest and the low floor of $25 to begin to invest in this instrument be included in the Benefits section as an advantage of I Bonds? And shouldn’t the gifting strategy be included in the Purchase Limits section, along with an short explanation of the Gift Box and delivery process?
Question: I purchased an I-Bond in September 2022 (money was withdrawn from my account in late December). My rate did not include the fixed .4% which is offered during the current purchase cycle. When my first 6-months period ends and a new rate cycle will commence (in July I believe?), would I then automatically get locked into whatever the current rate will be, including a possible fixed rate such as the current .4? Thanks
If you bought in September 2022, it seems odd that the money was not withdrawn from your account for several months. But TreasuryDirect was having issues. If the purchase was officially in September, then you will be earning 9.62% six months, and then beginning in March, 6.48% for six months. Your fixed rate is 0.0% and will never change.
I have a few suggestions that could make this work:
1.) Mandate the Treasury Department revive the public campaign to educate and encourage Americans to buy Savings Bonds and/or participate in the Payroll Savings Program;
2.) Mandate the Treasury Department to automatically create Treasury Direct accounts for Americans via their Social Security numbers;
3.) Allow people to use prepaid credit/debit cards in lieu of a conventional bank account as a means to purchase Savings Bonds in TreasuryDirect;
4.) Give people the option to purchase savings bonds directly through their online banking service;
5.) Sell Savings Bonds through point-of-sale methods at post offices, grocery stores and department stores (Wal-Mart, Target, etc.), and have them automatically registered with TreasuryDirect. Once the bonds are registered, the purchaser could either choose to have a certificate e-mailed to them, or have a conventional paper bond printed from an computerized template provided by TreasuryDirect.
Regarding suggestion #5, up until 2012, savings bonds could be purchased at many banks. A person could walk into their local bank and request to purchase a savings bond. The money would be withdrawn from their bank account, and several days later, the US Treasury would mail the paper bonds to the requester.
The following link is to a press release, announcing the end of over-the-counter sales of paper savings bonds, beginning January 1, 2012. By moving to electronic savings bonds, issued through TreasuryDirect.gov, the change saves the US Treasury $14 million per year.
https://www.treasurydirect.gov/news/2011/release-07-13/
Nonetheless, I do agree with you. For many people, the TreasuryDirect web site may seem awkward to navigate. Buying and redeeming paper bonds through a local bank would make savings bonds much more accessible to many more people.