As inflation drives prices of everyday goods painfully higher, what can you do to defend your money? One lesser-known type of investment might help safeguard your cash – but before you buy in, make sure you understand its strengths and weaknesses.
Understanding I Bonds
I Bonds are inflation-protected savings bonds, issued and guaranteed by the United States Treasury to protect your money from losing value to inflation. They earn a monthly interest rate that’s usually close to or higher than the Consumer Price Index (CPI), one of the most popular measures of inflation. The interest rate paid by I Bonds comprises two components: a fixed rate set when the bond is issued, which remains the same for the 30-year life of the bond, and an inflation rate that changes twice a year, in May and November.
The CPI increased by 9.1% year over year in June 2022, the highest inflation rate in nearly 40 years. As of July 2022, the fixed rate on an I Bond is 0.00%, and the inflation rate is 9.62%, guaranteed for the first six months. That rate will rise or fall based on changes in how quickly the CPI grows.
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I Bonds continue to earn interest unless you cash them first. If you hold them for less than five years, you lose any interest you would have accumulated for the last three months. The interest payments from I Bonds accrue, meaning you only get your proceeds when you sell the bond – or, if you hold it for 30 years, when it matures.
Consumers can buy I Bonds through the government’s TreasuryDirect website. Make sure you name a beneficiary when purchasing I Bonds, so that if you die before they mature, they can pass to a loved one or family member.
While I Bonds are exempt from state and local taxes, you’re still responsible for paying federal taxes. You can either report interest every year on your tax return, or defer taxes until you redeem the I Bond. Most people choose the latter approach, since they’ll otherwise need another source of income to pay those taxes.
You can also use I Bonds to pay for college by opening a separate account for an eligible child. The interest you earn is tax-free if you use those funds for qualified higher education expenses. In times of high inflation, that can make I Bonds a great alternative or supplement to 529 savings plans.
Downsides and alternatives
Besides I Bonds’ impressive rates, there are a few things to consider before you jump in with both feet. I Bonds’ maximum investment limit is only $ 10,000 per person per calendar year, and they can not be redeemed for at least 12 months from the purchase date. Moreover, there is a penalty equal to three months’ interest if you cash out sooner than five years. Of course, this is not a dealbreaker for most investors at these rates.
Treasury Inflation-Protected Securities (TIPS) are also a type of bond issued by the US government. The principal of a TIPS increases or decreases with inflation and there is no limit on the purchase amount. Additionally, TIPS can be bought and sold in the secondary securities market (from your brokerage account) in the form of an ETF or mutual fund.
TIPS have no investment limits, and you can redeem them anytime. But TIPS do not benefit from tax deferral. Even though you will not get any cash from TIPS ‘semi-annual inflation adjustments until you sell them or they reach maturity, you’ll still have to pay taxes on those gains.
Are I Bonds right for you?
I Bonds are ideal for investors with $ 10,000 or less to invest, who would sleep better at night knowing their exact rate of return. Remember, I Bonds tie up funds for at least one year, and they can not be used for emergency savings.
If you’re saving for college, I Bonds are more flexible than 529 savings plans. You can use the funds for educational purposes, but you do not have to, in case your desired recipient gets a large scholarship, decides to go to a trade school, or otherwise does not need to cover college costs. In that case, you’ll just pay normal federal income tax on the I Bond’s gains – but you will not have to worry about penalties that a 529 savings plan for using its funds for non-educational purposes.
No matter what your investing style or financial goals are, hedging against inflation is the ultimate goal during these tough times. If your needs match what they offer, I Bonds might be able to help you reach that goal.
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Fool contributor Alka Mehta holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.