Last week I noted that Series I Savings Bonds are now paying 3.36% (current as of 11/09). Given current CD rates, this makes them a rather attractive alternative to bank CDs. That being said, a lot of people aren’t familiar with them, and are thus unlikely to use them.
What is a Series I Savings Bond?
Series I Savings Bonds (also referred to as “I Bonds”) are a low-risk, inflation-indexed savings instrument issued by the Federal government. Unlike CDs, which have a fixed interest rate, I Bond rates are adjust semi-annually based on the prevailing inflation rate, in May and November.
The I Bond rates is actually made up of two components, a fixed rate that sticks with the bond over its lifetime and a variable rate that changes every six months based on the Consumer Price Index (CPI).
How to Purchase I Bonds
You can purchase I Bonds in one of two forms: electronic or paper. Electronic purchases are done via TreasuryDirect, whereas paper bonds can be purchased (with no fee) from most banks.
The primary limitation with I Bonds is that you can only purchase $5k worth of them (per format, so $10k total) per calendar year per social security number. The good news is that you can convert your paper bonds into electronic format following the purchase.
Electronic I Bonds can actually be purchased in any amount between $25-$5k, whereas paper bonds are issued in denominations of $50, $75, $100, $200, $500, $1000, and $5000.
Advantages of I Bonds
Aside from providing inflation protection, I Bonds offer some tax advantages, as well. For starters, the interest accrues within the bond itself, so you are not taxed on the proceeds until you choose to redeem the bond (more below).
A second tax advantage is that I Bonds are not subject to state income tax, such that the tax equivalent yield is actually higher than that of an equivalent, fully taxable investment.
Note: Jim also made the excellent point in the comments that interest on I Bonds (as well as EE Bonds) is tax-free if used for college tuition (with some restrictions; details).
Redeeming I Bonds
I Bonds have to be held for a minimum of one year before they can be redeemed, and they cannot be transferred through market sales. In other words, once you buy one, your money is locked in for 12 months. Period.
You can redeem your I Bonds between 1-5 years after purchase for a three month interest penalty. After five years, you can redeem your I Bonds without a penalty. If left untouched, your I Bonds will continue to earn interest for up to 30 years.
Are I Bonds right for you?
The answer to this question will depend on your circumstances, but I’m of the opinion that I Bonds can be a great alternative to CDs. The reason for this is that they provide inflation protection and they also offer a few tax advantages (noted above) as compared to CDs.
Look at it this way… If you buy one today and have to break it in a year, you’ll have earned a little better than 2.5% after paying the three month penalty (assuming rates remain the same). In the mean time, if inflation kicks up, so will your interest rate.