- The interest rate of I-bonds is now 0.2 + 2*inflation rate
To the dismay of Neo-Keynesians, the Treasury has increased the fixed rate of I-bonds from 0 to 0.2%. It is odd that the government would increase it when unemployment is still so high level, but it reflects their fear of future inflation. Nevertheless, this is good news if you are in the market for safe, tax-efficient, inflation protected bonds.
The I-bond rate is re-evaluated every six months, and is equal to (fixed rate + 2 x inflation rate). Thus, I-bonds serve the same purpose as Treasury Inflation Protected Securities (TIPS), except with far more tax-efficiency.
Every individual and corporation can buy up to $10,000 I bonds a year. They can not be redeemed in first year. You will lose the last 3 months of interest penalty if you redeem before 5 years. Federal income-tax on I-bonds are deferred until redemption or maturity (30 years), and there are no municipal taxes.
Downsides to I-bonds
You will eventually have to pay federal taxes on the interest*, so they aren't as tax-efficient as anything in an IRA account. They are also very safe asset which isn't a downside as long as you treat them like one.
The biggest downside is that that if inflation doesn't pick up, which there is no reason to believe it will anytime soon, I-Bonds are not going to earn you much more than 2% real returns. But what bonds will?
The Best Way to Use I-bonds
Say your risk allocation is 80/20 stocks : bonds. All your bonds are in an IRA account, as they are less tax-efficient than bonds. You could sell up to $10,000 of those bonds and buy an equal amount of I-bonds, thus freeing up $10,000 in your IRA for stocks. You would take a tax hit on the bonds, but make it up with the tax you save by buying stocks in an IRA rather than a taxable account (capital gains tax + state tax+ municipal tax).
Here is an estimate of the difference if you are in the 25% tax bracket:
Tax difference from buying I-bonds instead of bonds through an IRA:
·Your LOSS: income tax* bond interest = 0.25 * (a relatively small amount)
Tax difference from buying stocks in an IRA rather than a taxable account
·Your GAIN: ((capital gains tax + municipal taxes) * stock growth) + (income tax * Stock Dividends)
(0.15+ m)*(a relatively high amount) + (.25* a relatively small amount) where m is 0 if you live in a tax-free state, but could be .06 or higher depending on where you live.
*unless you use them to pay for qualifying education expenses, like a child's college tuition.