Several people have asked why I like Series I savings bonds, so I thought I’d address that with a dedicated post…
For context, the Treasury has recently announced that they’re (mostly) getting rid of paper savings bonds, which effectively cuts the annual purchase limit in half (from $5k paper + $5k electronic to just $5k electronic). While you can work around this limitation by buying savings bonds with your tax refund, that’s a bit of a hassle.
For starters, I bonds offer a degree of inflation protection, as their rate (updated every May and November) is partially pegged to the CPI. The rate is actually made up of two components – a variable rate calculated from changes in the CPI and a fixed rate that represents a premium over inflation.
Recently, the fixed rate has been pegged at 0%, which means that you have to depend on that variable rate to generate your return. In other words, your “real” (inflation adjusted) return is 0% before taxes. Not great, but at least you’re not lagging behind inflation, as you would if you stuck your money in a savings account.
Another nice feature of savings bonds (both I and EE bonds) is that the interest is exempt from both state and local taxes, and federal taxes aren’t due until the bonds are redeemed. Thus, savings bonds give you an IRA-like tax deferral in addition to existing IRA contribution limits.
And guess what? If you use your bond proceeds to pay for college, the interest income will ultimately be tax free (subject to restrictions; details). Thus, they can be a nice complement to things like a 529 plan.
Effectively higher rates
A common criticism of I bonds is that, due to the low (currently zero) fixed rate, you’re guaranteed to lose to inflation after taxes, even with the state and local tax exemption. As I’ve noted above, this isn’t entirely true, as you can use the proceeds to pay for college and get a federal tax exemption.
To crystallize the above points, let’s take a look at the tax equivalent yield of current I bonds. As of May 2011, the variable rate stands at 4.6%. Compared to available savings and CD rates, this is quite high. Sure, it might drop in the future, but only if inflation likewise declines.
So what about the tax equivalent yield? The tax equivalent yield of an investment is the rate that you would have to earn in a fully taxable investment to equal the return that you’re getting in a tax-advantaged investment. You calculate it by dividing the rate of the latter by one minus the tax rate, as follows:
Tax Equivalent Yield = Tax-Free Yield / (1 â€“ (% Tax Bracket / 100))
Assuming that you live in a state with a 6% income tax rate, which is a fairly middle-of-the-road value, your tax equivalent yield on a current I bond would be roughly 4.9% – not too shabby. But wait! What if you’re planning on using it to pay for college, and you’re in the 25% tax bracket? In that case, (25% federal + 6% state) your tax equivalent yield would increase to nearly 6.7%!
Yes, your rates will bob up and down every six months, but it’s hard to argue with those sorts of numbers given the current interest rate landscape. Of course, if you live in a state with no income tax, the numbers will change, but that federal exemption is still a big deal.
Reasonable redemption policies
Finally, we have to consider getting your money back out… Sure, you’ll get better-than-bank interest rates, but what good is that if you can’t access your money? There’s good news and bad news here. For starters, you can’t redeem your savings bonds during the first 12 months. Period.
Once 12 months has passed, however, you can redeem for a 90 day interest penalty. And this penalty could be very low if you do it during a period of low inflation (when rates are at their lowest). After five years, the penalty goes away entirely.
So there you have it… We like Series I savings bonds for the combination of inflation protection and tax advantages – and the accompanying boost in terms of tax equivalent yield. They’re not sexy, and they’re not exciting, but they are a valuable part of our portfolio.