I Bonds: Protecting Your Portfolio from Inflation
With a rising inflationary environment—the highest in four decades—investors are seeking shelter in low-risk investments to protect their portfolios. As a result, there has been record demand for I Bonds, a nearly risk-free diversification strategy to hedge against market volatility.
What are I Bonds?
I Bonds are savings bonds issued by the US Treasury. These are relatively safe investments because they are backed by the government and cannot lose value over time, as the interest rate cannot go below zero. I Bonds carry a zero-coupon interest rate, meaning that instead of receiving interest payments, the bond trades at a discount to its face value, which then gets paid in full at the time the bond matures.
The maturity date of an I Bond is 30 years, when the bond will reach the end of its term. They can be cashed in any time between 12 months and 30 years, but if they are sold before five years, the investor forfeits the last three months of interest. There is no penalty for redeeming the bonds after five years.
As a way to protect from inflation, interest rates on I Bonds are reset every six months and adjusted regularly to keep up with rising prices. Typically, when interest rates rise, bond prices fall, and vice versa.
How to Buy I Bonds
I Bonds are sold electronically by the US Department of Treasury through the TreasuryDirect platform and can be purchased for as little as $25 or up to as much as $10,000 per year. Creating an account online can be tricky since the platform is somewhat outdated, so patience is key.
To begin, select “Open an Account” on the right-hand side of the website’s homepage. Be sure to indicate a “TreasuryDirect” account, and then follow the prompts to enter your personal identification information. You will need basic information, as well as your Social Security number, the name of the bank to link your Treasury account, and banking/routing numbers. Once your account has been created, you can purchase a set number of bonds and/or schedule recurring purchases at a particular frequency or on a certain date.
Investors also have the option to purchase paper I Bonds by mail with the proceeds from their federal income tax return with a minimum purchase of $50 and maximum purchase of $5,000 per year. To do this, investors will need to include IRS Form 8888 Allocation of Refund and specify—in increments of $50—how much of their refund should be allocated toward the purchase of I Bonds.
I Bonds can also be given as gifts. Investors can use Form 8888 to gift these bonds to others, which will be counted as a gift in the year of purchase, not in the year redeemed. If the total gift amount exceeds the annual exclusion ($16,000 in 2022), investors are required to file a gift tax return on Form 709.
Interest Rates on I Bonds
I Bonds are currently offering an annualized interest rate of 9.62 percent through October 2022. That is particularly attractive given the market rollercoaster since January.
So, how do these Treasury Bonds calculate interest rates? It’s two-fold—there is a fixed rate and a variable rate. These two rates are combined to form a composite rate, which is the 9.62 percent mentioned above. The fixed rate is given at the time of purchase and does not change. The variable rate is correlated to the Consumer Price Index and changes every six months based on inflation.
Fixed rates and variable rates are both announced on the first business day of May and November each year. This means, if an investor purchased I Bonds on September 1, 2022, the initial six-month rate of 9.62 percent would apply through February 28, 2023. Beginning on March 1, 2023, the November rate would kick in.
Fortunately, I Bonds are not subject to state or local tax. Any interest earned will only be subject to federal tax when the bond matures or when an investor sells the investment. However, some exceptions apply to qualifying educational expenses.
To qualify for an education tax exclusion, investors must cash in the I Bonds and pay for the tuition in the same year as the exclusion is claimed. Investors must also have been 24 or older before savings bonds were issued and have modified adjusted gross income less than $98,000 filing single or $154,800 married filing jointly.
If you have any questions on how to purchase or sell I Bonds or how to claim them on your tax return, please reach out to an R&A advisor.
About this Author
Dave specializes in tax research, estates and trusts, complex partnerships, and corporate, not-for-profit, and private foundation tax compliance.