I Savings Bonds
I Savings Bonds are issued by the U.S. Treasury and pay an interest rate composed of a fixed rate that lasts for the duration of the bond plus a variable inflation rate that is determined twice a year. These two rates combined (fixed rate + inflation rate) are referred to as the composite rate. At the end of 2011, the fixed rate was 0% and the annual inflation rate was 3.06%. Since I Bonds debuted in 1998, the composite rate for newly issued bonds has ranged from 7.5% (May 2000) down to 0% (May 2009 to present). The composite rate for I bonds issued November 1, 2012 – April 30, 2013 is 1.76%.
Individuals can buy only $5,000 in I Savings Bonds each year. Despite the limitation, advisors should seriously consider this asset for a portion of clients’ conservative money. Since 1999, I Bond rates have been substantially higher than money market fund yields every year. For example, money market funds had a total return of ~ 0.1% in 2012 while I Bonds returned almost 5%. Moreover, these often-ignored government securities have a number of advantages over TIPS:
- Interest payments are tax deferred for up to 30 years
- Interest is exempt from state income taxes if used for educational purposes
- In some instances, interest is exempt from federal and state income taxes
- Unlike TIPS, I Bond interest rates cannot fall below 0%
I Bond investors can cash in their bonds after five years without a penalty. After holding these bonds for one year or longer, the penalty is equal to three months’ interest. The $5,000 annual limit applies to each member of a family; a family of five could buy $25,000 of I Bonds each year. Starting in 2012, taxpayers can opt to have their refund paid in the form of I Bonds. This means each investor could effectively buy $10,000 worth of I Bonds each year (a $5,000 direct purchase plus a $5,000 tax refund). Because of this loophole, some investors are intentionally overpaying their taxes up to $5,000.