Buying Tax Free I-Bonds

Savings vs Investing, Keeping up with Inflation

The best investment for any entrepreneur is usually to grow the business, but what if you're up against a dead end or just temporarily on hold? In 2003, I bought a $10,000 I Bond, a 30 year, inflation adjusted savings bond backed by the full faith and good intentions of the United States government. The money had been sitting in a savings account paying less than 1%, and it didn't look like I'd need it for a year, and the I-bonds are adjusted twice a year for inflation (or deflation, which doesn't worry me). After 1 year, the bond can be cashed at any time, with a penalty of 3 months interest, the same as most CDs. After five years, there is no penalty. Plus, interest on federal bonds is state tax free. Last month, January 2012, I bought another $10,000 I Bond, this one yields 0%, but it's inflation protection since the yield can't go negative.

So, how much do I Bonds pay? I Bond interest rates are built from two components, the fixed rate the bond pays at purchase time, plus the inflation rate that is adjusted every six months. Both rates are computed or set on May 1st and November 1st of each year. Fixed rates are low, so the real hope is that the inflation rate will make up for it. In fact, the inflation rate for adjusting I Bonds in May 2009 was -2.78%, which brings out the strength of I Bonds over TIPS (Treasury Inflation Protected Securities). When the inflation rate is reported as negative (deflation) and the interest rate isn't enough to offset it, the I Bond pays 0% for that six months, but it never shrinks. TIPS, on the other hand, always pay out the interest, but the principal is adjusted with inflation or deflation, meaning you can lose money on them. The problem is any case is that the government inflation figures are based on the CPI, which which is designed to measure cost of living rather than inflation. For example, medical costs make up just 6% of the CPI-U while they are closing on 20% of the GDP! So, the whole thing is a cheat, but what can we do:-) The following table (information from the Treasury Direct Site) lets you calculate the rate the I Bonds are paying based on the issue date. The inflation rate column is shown for historical interest, but it's only the most recent inflation rate value that's being used to compute the total return for your I Bond at any given time:

Date Purchased Fixed Interest Rate Semi-annual Inflation Rate

Nov 2011 - April 2012 0.00% 1.53%

May 2011 - Oct 2011 0.00% 2.30%

Nov 2010 - April 2011 0.00% 0.37%

May 2010 - Oct 2010 0.20% 0.77%

Nov 2009 - April 2010 0.30% 1.53%

May 2009 - Oct 2009 0.10% -2.78%

Nov 2008 - April 2009 0.70% 2.46%

May 2008 - Oct 2008 0.00% 2.42%

Nov 2007 - April 2008 1.20% 1.53%

May 2007 - Oct 2007 1.30% 1.21%

Nov 2006 - April 2007 1.40% 1.55%

May 2006 - Oct 2006 1.40% 0.50%

Nov 2005 - April 2006 1.00% 2.85%

May 2005 - Oct 2005 1.20% 1.79%

Nov 2004 - April 2005 1.00% 1.33%

May 2004 - Oct 2004 1.00% 1.19%

Nov. 2003 - April 2004 1.10% 0.54%

May 2003 - Oct. 2003 1.10% 1.77%

Nov.2002 - April 2003 1.60% 1.23%

May 2002 - Oct. 2002 2.00% 0.28%

Nov. 2001 - April 2002 2.00% 1.19%

May 2001 - Oct. 2001 3.00% 1.44%

Nov. 2000 - April 2001 3.40% 1.52%

May 2000 - Oct. 2000 3.60% 1.91%

Nov. 1999- April 2000 3.40% 1.76%

May 1999 - Oct. 1999 3.30% 0.86%

Nov. 1998- April 1999 3.30% 0.86%

September 1998 3.40% 0.62%

Remember that you aren't simply adding the two columns together to get the return, if it was that easy, I'd have done it here. The return is the fixed rate from the period during which you bought the bond plus (or minus) the inflation adjustment in the last semi-annual period for the I Bond multiplied by 2, since the inflation rate only covers six months while the fixed rate is annual. I don't know what the last factor is for, it will normally round down to nothing in any case.

The total I Bond return is = [Fixed rate + (2 x Semi-annual inflation rate) + (Fixed rate x Semi-annual inflation rate)]

So bonds sold in the current six month period will pay 3.06% during the period, and then readjust in April 2012.

I'm not getting rich on I Bonds, nobody is, but they are the best "sleep at night" savings I have. And the interest on I Bonds compounds tax free until you cash them in, which barring emergencies, you can do in a low income year when you'll pay a low marginal tax rate on the interest.

If the inflation rate reported by the government goes negative (deflation), it can cancel out the fixed interest rate your I Bond would have paid, but the redemption value of a Series I bond will never drop on a month to month basis. That's another way of saying that a 0% I Bond can't lose money in dollar denominated terms, so to the extent that we accept the official inflation numbers, even the 0% I Bonds offer pre-tax inflation protection. Too bad the limit is $10,000 per year.

I'm not the bond expert, in fact, I didn't even know that the $10,000 I-Bond I bought through Treasury Direct could be partially cashed until I read "Savings Bond Alert" by Tom Adams. It includes far more up-to-date information related to owning and cashing savings bonds than I saw on the Treasury Direct site, despite the fact they sell the things! A option to buying bonds with the some tax advantage is to buy note or treasury bills.

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