I bonds

What Are I-Bonds?

I-bonds are a type of U.S. government savings bond designed to protect investors from inflation. Issued by the U.S. Department of the Treasury, these fixed income securities offer a unique composite interest rate that adjusts periodically to reflect changes in inflation. Unlike other Treasury bonds or Treasury bills, I-bonds are non-marketable, meaning they cannot be traded on the secondary market but must be purchased directly from the U.S. Treasury through its TreasuryDirect system. Their primary appeal lies in their ability to preserve the purchasing power of an investor's principal over time.

History and Origin

Series I Savings Bonds were introduced by the U.S. Department of the Treasury in September 1998. The creation of I-bonds aimed to provide individual investors with a simple and accessible way to invest in a low-risk product that offered protection against rising prices. This initiative followed a period where inflation had eroded the real returns on traditional savings vehicles. The U.S. Treasury continues to be the sole issuer of these bonds, making them a direct obligation of the U.S. government. Information about the rates and structure of I-bonds is routinely updated and available through official government channels.¹⁷

Key Takeaways

• I-bonds are low-risk U.S. government savings bonds that offer protection against inflation.
• Their interest rate is a composite of a fixed rate and a variable inflation rate, adjusted every six months.
• Interest earned on I-bonds is exempt from state and local income taxes, and federal taxes can be deferred until the bond is redeemed or matures.
• There are annual purchase limits, and bonds must be held for at least one year. Early redemption penalties apply if cashed in before five years.
• I-bonds are non-marketable and must be purchased directly from TreasuryDirect.

Formula and Calculation

The interest rate on an I-bond is a composite rate, calculated by combining a fixed rate of return and a semiannual inflation rate. This ensures that the bond's value keeps pace with inflation. The formula for the composite rate is:

Where:

• Fixed Rate: A real rate of return that remains constant for the life of the bond. This rate is announced every May and November.
• Semiannual Inflation Rate: This rate is based on changes in the non-seasonally adjusted Consumer Price Index (CPI) for all Urban Consumers (CPI-U) over a six-month period. It is also announced every May and November.

For example, if the fixed rate is 1.10% and the semiannual inflation rate is 1.43%, the calculation for the composite rate is as follows:

The interest earned on I-bonds is compounded semiannually, meaning that every six months, the accrued interest is added to the bond's principal value, and future interest is calculated on this new, higher principal.¹⁶

Interpreting the I-Bonds

Understanding the interest rate of I-bonds involves recognizing the interplay between their two components: the fixed rate and the inflation rate. The fixed rate represents the "real" return an investor earns above inflation, locked in for the bond's entire 30-year term. The inflation rate, on the other hand, is variable and designed to offset the impact of rising prices. When inflation is high, the variable component increases, leading to a higher overall composite interest rate. Conversely, in periods of low inflation or deflation, the variable component will decrease, potentially bringing the composite rate closer to, or even below, the fixed rate. The U.S. Bureau of Labor Statistics publishes the CPI data that forms the basis for the inflation rate component.¹⁵ This structure provides a dynamic mechanism for preserving purchasing power within an investment portfolio.

Hypothetical Example

Consider an investor, Sarah, who purchases an I-bond for $10,000 in May 2025. For the first six months, the bond earns the current composite rate of 3.98% (composed of a 1.10% fixed rate and a 1.43% semiannual inflation rate). After six months, the interest earned is added to her principal, and a new composite rate, based on the fixed rate and the updated inflation rate, is applied for the next six months.

If the bond earns approximately 1.99% for the first six months (half of the annualized 3.98%), her bond value would increase to $10,199. For the next six months, a new inflation rate is determined, and this new composite rate would be applied to her now $10,199 principal. This process of compounding every six months allows her investment to grow not just from the interest percentage, but from the fact that interest is calculated on a continuously growing balance until the bond reaches its maturity.

Practical Applications

I-bonds are widely used in financial planning for several strategic purposes due to their inflation protection and tax benefits. They are particularly popular for building an emergency fund that is protected against the erosion of purchasing power. Many families also utilize I-bonds as a component of their college savings strategy, as interest earned may be tax-free if used for qualified higher education expenses, subject to income limitations and other conditions.¹⁴,¹³ The interest on I-bonds is tax-deferred at the federal level until redemption or maturity and is entirely exempt from state and local income taxes. This makes them an attractive option for investors looking to minimize their tax burden on savings. Individuals can purchase I-bonds electronically through TreasuryDirect.gov, with an annual purchase limit of $10,000 per person.¹²

Limitations and Criticisms

Despite their advantages, I-bonds have certain limitations. The most significant is the annual purchase limit, which is $10,000 per individual for electronic bonds and an additional $5,000 if purchased with a federal tax refund. This restricts the amount of money an investor can allocate to I-bonds, making them less suitable for those looking to invest large sums in inflation-protected assets.¹¹,¹⁰

Another limitation is liquidity. I-bonds cannot be redeemed within the first 12 months of purchase. Furthermore, if redeemed before five years, an investor forfeits the last three months of interest.⁹,⁸ This early withdrawal penalty can reduce the overall return, making them less ideal for very short-term savings. While they offer protection against inflation, their returns might be lower compared to other investment vehicles during periods of low inflation. Some investors also find the process of buying and managing I-bonds through the TreasuryDirect website less intuitive compared to brokerage accounts, potentially creating a "hassle factor" for smaller allocations.⁷

I-Bonds vs. Treasury Inflation-Protected Securities (TIPS)

Both I-bonds and Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury securities designed to protect investors from inflation, but they differ significantly in their structure and how they are bought and sold.

The primary point of confusion often arises from their shared goal of inflation protection. However, their mechanics are distinct. I-bonds guarantee that the initial principal will never decline, even if the CPI drops. TIPS, on the other hand, adjust their principal value directly based on inflation, which can lead to a decrease in principal value during periods of deflation, though the original principal is returned at maturity. TIPS are also traded on the open market, allowing for greater liquidity and price fluctuation based on market demand, unlike I-bonds which are held directly with the government.

FAQs

Q: How do I purchase I-bonds?
A: You can purchase I-bonds directly from the U.S. Department of the Treasury through its online platform, TreasuryDirect. An account needs to be set up to buy and manage these savings bonds.

Q: Can I lose money with I-bonds?
A: The principal investment in an I-bond is protected and will never decrease, even if there is deflation. However, if you redeem the bond before five years, you will forfeit the last three months of interest rate earnings as a penalty.⁶

Q: Are I-bonds taxed?
A: Interest earned on I-bonds is exempt from state and local income taxes. Federal income tax on the interest can be deferred until the bond is redeemed or matures, up to 30 years. Additionally, the interest may be entirely tax-free at the federal level if the proceeds are used for qualified higher education expenses, subject to specific income requirements.⁵,⁴

Q: What is the maximum amount of I-bonds I can buy in a year?
A: As of January 1, 2025, individuals can purchase up to $10,000 in electronic I-bonds per calendar year through TreasuryDirect. Previously, an additional $5,000 in paper I-bonds could be purchased using a federal tax refund, but this option has been discontinued for 2025 onwards.³,²

Q: How long do I-bonds earn interest?
A: I-bonds earn interest for up to 30 years from their issue date or until you cash them, whichever comes first.¹