Hey, what's up, everyone and welcome to the School of Personal Finance. Today, I'm going to be talking about I bonds. Now, I have mentioned them in some of my most recent videos, and what a great opportunity I think they are right now. I'm going to tell you what they're all about, the things you need to look out for and why I think it is a great time to go ahead and pull the trigger and buy US government I bonds in this high inflationary period. All right, let's get to it.
If you would like to watch the video instead click here
What are I Bonds?
The I stands for inflation. They are bonds that are issued by the US Treasury. You have to go to a website, TreasuryDirect.Gov, and set up an account to purchase these I Bonds. Now, the interest rate, the way that it works, they have two components. It has a fixed rate and a variable rate. The fixed rate, depending on when you purchase the I bonds, is locked in for the life of you owning those I bonds. The current fixed rate is zero and it's been zero for a while.
Then they also has a variable rate. And the way that it works is the variable rate is locked in for six months and then it changes depending on the rate of inflation. This is measured by the Consumer Price Index (CPI). The CPI in March was 8.5%. That is the highest that we have seen in four decades. I bonds are currently at the highest interest rate that they have ever been for the inflation component. That six-month rate is going to be locked in and then it will reset depending on where inflation is at that time.
Before I go over the current rates and walk you through a very simple example, let's first start with some downsides and some things that you need to know if you do want to go ahead and purchase these. The first thing is you are limited to $10,000 per individual per calendar year. If you are married, you could buy $10,000 under your name and your Social Security number and you can also buy $10,000 under your significant other's name and Social Security number. You can also give them to your children, for example, using their name and their Social Security number but keep in mind that gifts are irrevocable. When you give that money to somebody else, that becomes their money. You can't take the gift back from them.
Also, if you have a business like an LLC or a Scorp you can purchase these I bonds under the tax ID number of the business. You're also able to buy up to an additional $5,000 using your tax refund. If you get a tax refund you could use that money to directly buy paper I bonds from the government.
How long can you hold I Bonds?
Now the next important point is that you need to hold them for at least one year. This is not a good replacement for your emergency fund. This is money that you have to go in knowing you have zero access for at least the next twelve months. Then beyond that, if you sell them before five years, they have a penalty. The penalty is going to be the most recent three months of interest. For example, if you purchase $10,000 worth, hold them for 15 months, and then you need the money and you decide to sell them, you're going to be penalized for the last three months interest. You will only have earned the first twelve months of interest on those bonds.
I Bonds will pay you interest for up to 30 years. As long as you hold them for more than five years, then there will be no penalty when you redeem them.
When do the Interest rates change?
Let's use a very simple example. Now, it's important to understand that the rates change every May 1 and November 1. Whatever the rate is at the time you purchase them, that will be the rate on your I Bonds for the next 6 months. That's a little bit confusing. So if you buy right now in April, it's 7.2% is the current rate. That rate will be locked in for you for the next six months. Even though they're going to announce a new rate on May 1, your rate is not going to change on May 1. Your rate is locked in for six months from the date of purchase. So I think it's a smart idea to purchase right now, because if you do so, you are locking in this all-time rate of 7.2% for the next six months, and then six months from now, you're going to lock in the new rate, which is going to be announced on May 1. This new rate, it's looking like it is going to be 9.62% based on the last six months of inflation numbers, so if you buy now, you get 7.2% for six months, then your rate is going to adjust six months from now.
Let's say in October, you are going to adjust to the current rate, which is going to be 9.62%, and that will be locked in for six months. So that is an annualized rate of around 8.5%. It's a little bit more than that because of the interest compounds every six months. So you get that 7.2% for the six months. That interest will then be added to your bonds, and then you'll earn 9.62% on that amount for the next six months. Then what happens six months later is it will adjust to whatever the new rate is.
Now we can't see into the future. We can't predict what inflation is going to be six months from this new date. The rates could go lower. If we've hit peak inflation, then the next adjustment down the line, the rates might start to go down, but nobody knows what's going to happen at that point. If inflation stays high the rates on these, they're going to continue staying high. The interest is backed by the US government. There's no risk of loss of principal. You can't lose any money on this. The only thing that could happen is you could have that penalty, that three-month penalty if you sell before five years.
Another thing to keep in mind is that you can't purchase I Bonds inside of your IRA or your Roth IRA or your employer-sponsored plan. The only way you can buy these is with after-tax money that you have in a savings account or the brokerage account If you currently have a portfolio in the brokerage account and you have a bond piece in that portfolio, this can be a great replacement for some of that.
Why should you buy I Bonds?
There's some risk to owning other types of bonds right now like corporate bonds municipal bonds. There could be a lot of risks depending on what types of bonds you own. If you could replace some of that with a guaranteed interest rate of 7- 9% right now and lock that in for a year, that is an amazing rate with zero risk. Another great situation could be if you just have a lot of money in a savings account, maybe you're saving for a down payment on a house a few years from now, or you just have the extra money in your emergency fund that you're sitting on because you don't want to invest it. Maybe you have that earmarked for something in the next few years. Putting that money into I Bonds right now, to me it's a no-brainer. As long as you go in with the understanding that you have to hold them for a year and that if you sell before five years that you're going to be penalized with the last three months worth of interest, then I think they make a ton of sense for people out there that are just sitting on a lot of cash. It's just a great replacement for that right now.
Another positive is that even though you will owe federal tax on the interest, it is not subject to state tax. So that is another advantage. For safe, secure money you could get like 8% on right now, that sounds pretty amazing to me. The Treasury Direct website has a ton of information where you could learn more. They describe exactly what bonds are. They show all the historical interest rates. It actually wasn't that long ago that the interest rate on these was zero because we really haven't had inflation in decades but here we are with very high inflation so these rates have jumped up and now they're paying very attractive rates.