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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And a few weeks ago, one of our listeners, John R., emailed me asking if I thought I-bonds were a good investment. And while some people have gone as far as suggesting that I-bonds are, quote, the best kept secret in America, I simply told John that they should be thought of and used just like you would a CD or a money market account. And that some of their limitations actually discourage successful retirement savers from using them at all.
Before I explain why, let's first define what an I bond is in plain English, of course. So I bonds are a type of US savings bond, and they were created in 1998 by the US Treasury as a simple way to protect your money from losing value due to inflation. I bonds are able to do this because they have a unique return profile, which is essentially comprised of two parts, a fixed rate and an inflation adjusted rate.
The fixed rate is determined at purchase and remains the same throughout the life of the bond. And the inflation adjusted rate, well, it's adjusted regularly to keep pace with rising prices and combat inflation. The US Treasury announces the fixed rate for I-bonds every six months on the first business day of May and the first business day of November.
The inflation adjusted rate is also announced every six months on the same schedule. But unlike the fixed rate, which doesn't change for the life of the bond, the inflation rate can and usually does change on those announcement dates. Changes to the rate is based on the Consumer Price Index for urban consumers, also known as CPI-U.
Now, these two rates, the fixed and inflation adjusted, are combined and injected into a formula to get us to what's known as the composite rate or, quote, the actual interest rate on your I bond.
The equation that makes up this formula is the fixed rate plus two times the semi-annual inflation rate plus the fixed rate times the semi-annual inflation rate. Now, let's put some quick numbers to this. As mentioned, rates are announced on the first business day of May and November. And as of May 2021, the fixed rate of an I-bond was set at 0%. Yes, 0% is the current fixed rate of an I-bond.
But the inflation rate was announced in May, and that is 3.54%.
One important thing to note here, which is a very common misconception, is that that 3.54% inflation rate that's often quoted in the headlines is the annual rate of interest. Since this rate can and usually does change every six months, it's actually more accurate to cut this in half and quote 1.77% as the current semi-annual interest rate.
Oftentimes you'll see headlines that say, you know, "I bonds are paying 3.5% right now." But that's actually not true since that assumes the rate doesn't change for a 12 month time period, which again is unlikely. For example, the previous inflation rate that was announced in November of 2020 was 1.68% or stated more accurately 0.84% for six months.
In May of 2020, the six-month inflation rate was 0.53%, and before that, it was 1%. So as you can see, these rates move around quite a bit when they're announced every May and November. So let's go back to the current rates. 0% fixed rate and 1.77% six-month inflation-adjusted rate.
and let's plug those into the formula to come up with the composite rate also known again as the actual interest rate on the I bond that you're purchasing
so again the equation is the fixed rate plus two times the semi-annual inflation rate plus the fixed rate times the semi-annual inflation rate so right now that would be zero for the fixed rate plus two times the semi-annual inflation rate so two times 1.77 plus zero the fixed rate times
1.77% the semi-annual inflation rate. If we do the first step of this math problem, we essentially arrive at 0 + 3.54% + 0, which equals a composite rate of 3.54%. And if you're following closely, it's the same as the annual inflation adjusted rate. Now, the only reason the composite rate is the same as the annual inflation adjusted rate is because that fixed rate is zero.
which essentially renders the formula unnecessary in this particular situation because zero plus 3.54% plus zero, well, it equals 3.54%. When and if the fixed rate changes, the composite rate will be a different number than the inflation adjusted rate.
Speaking of the Fed, the fixed rate changing, while the rate doesn't change for the life of the bond that you buy, the rate does change on new bonds that are issued every May and November. So if you regularly buy I-bonds, you might end up with a handful of them that all have different fixed rates. And for what it's worth, the fixed rate was the highest back in 1998 when I-bonds were first issued. Back then, the fixed rate was 3.4%.
The fixed rate since then has continued to drop with it bouncing between 0% and half of a percent for the last 10 or 12 years or so. Okay, so on the surface, I bonds are sounding pretty good aside from the somewhat confusing rate structure and complex math problem that's required in order to determine your actual interest rate. But there are some major limitations that you need to be aware of before running out and just adding I bonds to your portfolio.
Number one, you must own the bond for one year before you can cash it in. And if you sell it within five years, you forfeit three months of interest. In other words, I bonds have an illiquidity element that's kind of similar to a bank CD.
Number two, you're restricted to buying $10,000 worth of I-bonds each year, although you can buy an additional $5,000 if you use your federal income tax refund, meaning you can acquire a total of $15,000 of I-bonds each calendar year, so you're limited to how many you can purchase.
Number three, like other US Treasury bonds, I bonds are exempt from state and local taxes, but interest earned is still subject to federal income tax. And then number four, I bonds are not eligible to be used in Roth IRA accounts. I know, I know we all love Roth IRAs, but they're not eligible for Roth IRA accounts. They can be owned in traditional IRAs and plain vanilla brokerage accounts though.
And then lastly, number five, it's not really a limitation, but just more of an FYI. And that is that I bonds have a 20 year maturity, although technically you can renew for another 10 years on top of that, boosting the maturity date to 30 years. But that's the maturity, say, a 30 year maturity date. Again, you can sell it after five years to avoid any sort of penalty and hold it for up to 30 years.
Now, none of these limitations cause really any major concerns. I bonds are pretty straightforward and provide a safe option for storing cash, combating inflation, and they're a good alternative to money under your mattress or any high yield savings account. However, there are two main reasons why successful retirement savers might not be racing out to buy I bonds every year.
The first is that given that you're limited to buying $10,000 worth of I-bonds per year, most people try to avoid getting a refund. So let's ignore the extra $5,000 that you can buy with your federal refund. Given that you're limited to buying $10,000 per year, successful retirement savers might determine that the juice just really isn't worth the squeeze here. For example, Chris Fliss, a fellow CFP professional shared the following example in a recent blog post.
Let's say your goal is to get 4% or $40,000 of your $1 million nest egg into iBonds. Keeping the math simple, that 4% that you want to go into iBonds, let's say is currently earning 1% in a money market account. And in this hypothetical example, iBonds will pay you 5%.
So you're going to take money from a 1% money market account and get into I bonds that will pay you 5%. Well, taking the return on 4% of your portfolio or $40,000, taking your return from 1% to 5% surprisingly only improves your total portfolio return by about 0.16% or $1,600.
Said another way you'll earn an extra $400 for every 1% of added return in this example $1,600 because you were able to take your return on that 1% money market account to 5% with I bonds now
Now, I'm not suggesting that 16 basis points or 0.16% or $1,600 is nothing, but for a lot of people, it just might not be enticing enough to go and open a treasury direct account, navigate the purchasing process and agree to the illiquidity constraints for one to five years just for an extra 0.16% boost to their million dollar portfolio.
In my personal experience as a financial planner, it's hard enough to convince clients to move cash from their day-to-day brick-and-mortar bank account paying them 0% to a high-yield savings account earning 1%. The idea of opening up yet another bank account, especially an online bank with no physical branches, and losing the convenience of accessing their money quickly through their day-to-day bank, it just isn't appealing to a lot of people.
And I think a lot of successful retirement savers have come to the same conclusion with I bonds. The second reason why successful retirement savers might not race to go buy I bonds is that there are better investment options available for combating inflation.
Not a safer option, but investing in the global stock market through low-cost index funds over long periods of time has proven to combat inflation better than bonds, cash, gold, real estate, you name it. So if earning a higher rate of return and combating inflation are really important to you, the best solution is likely staring you right in the face. It's not very sexy, and it might feel like there's some other magical solution out there that you just don't know about yet, but
Plain vanilla stocks historically have done the best job of accomplishing those goals over long periods of time.
Also, while I wouldn't argue that they are a better solution to I-bonds given that they do carry more risk, tips are also an option to consider for retirement savers who have inflation concerns and have fewer limitations. Plus, tips are a little easier to transact with. Now, that's not to say that you shouldn't consider I-bonds. There are plenty of good reasons to add them to your portfolio, and I've narrowed it down to three just to keep it simple for today.
Number one, as a successful retirement saver, you might just want to optimize and maximize every single last dollar, even if it means it takes more time to implement and more complexity and more limitations on accessing your money. For some people, squeezing every possible basis point out of their portfolio is really important to them. And if that's you, then you might consider I-bonds.
Number two, another reason to invest in I-bonds is an alternative college savings strategy for a child or grandchild. One thing I haven't mentioned yet is that I-bonds can be 100% tax-free if they're used to pay for college tuition and fees at an eligible institution. Remember, they're already state and local tax-free, but using them for qualified education expenses can render them federal tax-free as well. So that would be another reason to consider I-bonds.
Number three, lastly, investors with a lower net worth and or lower income will likely feel the benefits of I-bonds more than a higher net worth individual. The after-tax returns, remember taxes are really important in this calculation, the after-tax returns will be higher for someone in a lower tax bracket.
and the incremental difference in interest earned will make a much bigger impact on someone with, let's say, $100,000 of investable assets versus someone with a million dollars. Okay, that wraps up today's conversation on I-bonds. I hope it was helpful. And as always, if you have any questions on this topic or suggestions for a future topic, just send me a note to podcast at youstaywealthy.com.
Thank you, as always, for listening, and I will see you back here next week.