What it means
The point of an I bond is simple. If prices rise, the interest rate on the bond rises with them, so the money saved keeps its real value.
A normal fixed-rate bond cannot do that, because the rate is set on day one and inflation can eat away at the return. The overall rate, called the composite rate, combines the fixed rate with the inflation rate.
The fixed rate is set when the bond is issued and applies for its whole life. The inflation component is reset every six months, based on changes in a consumer price index (a measure of how much the prices of everyday goods and services have changed).
There are important rules on holding the bond. It cannot be cashed in during the first 12 months, and if it is cashed in before five years, the last three months of interest are lost.
A bond keeps earning for up to 30 years, and the Treasury sets a limit on how much any one person can buy each year, so I bonds suit small and medium savers rather than large institutions. Tax treatment is a large part of the appeal.
Interest is subject to federal income tax but exempt from state and local income tax, and the federal tax can be deferred until the bond is cashed in or reaches final maturity. Rates change, so a current figure should always be taken from the Treasury's own published announcements rather than from memory.
The nuance is that the composite rate cannot fall below zero, even if prices fall. That floor is valuable in a deflation, but it also means the bond is not a perfect inflation measure, because the fixed rate is the only guaranteed real return.
In practice
Real-world examples.
Example
A salaried employee puts part of her emergency fund into I bonds because she worries that rising prices will reduce what her savings can buy. She accepts that the money is locked up for the first year and treats the fund as a longer-term reserve.
Example
A small business owner buys I bonds in his personal name as a safe place to hold retirement savings alongside his business investments. His accountant notes that the interest can be reported when the bonds are cashed in, which defers the tax.
Example
A treasury analyst at a mid-sized charity compares I bonds with inflation-linked government securities that trade on a market. She concludes that the limits on purchases and the lock-up period make I bonds unsuitable for the charity's reserves.
Formula
Calculation
Composite rate = fixed rate + (2 x semi-annual inflation rate) + (fixed rate x semi-annual inflation rate)
Suppose the fixed rate is 0.90% and the inflation rate measured over six months is 1.50%. The inflation part is 2 x 1.50% = 3.00%. The cross term is 0.90% x 1.50% = 0.0135%. The composite rate is 0.90% + 3.00% + 0.0135% = 3.9135%, which rounds to 3.91% a year. On a $5,000 holding, the yearly interest is about 5,000 x 0.0391 = $195.50, and a six-month period earns about half of that, or $97.75.Case study
Seen in the real world.
Maplecrest Household Finance is an illustrative, fictional advice service. A couple came to it with $30,000 in a savings account earning little, and a worry that rising prices were shrinking their cushion.
The adviser explained that an I bond would adjust with inflation, and split the money between two bonds each year to respect the annual purchase limit and the lock-up rules. She was careful to tell them that the fixed part of the rate would stay low and that the headline composite rate would change every six months.
Two years on, the couple were pleased that the rate had followed prices, but they also noted the lesson the adviser had stressed: protection from inflation is not the same as a high return, and liquidity was the price they paid for it.
Watch out
Common mistakes.
- Assuming the composite rate announced today is locked in, when only the fixed part stays the same and the inflation part is reset every six months.
- Cashing in before five years without realising that the last three months of interest are forfeited.
- Counting I bonds as instantly available cash, when they cannot be redeemed at all during the first 12 months.
Questions
People also ask.
Can an I bond lose money?
The composite rate cannot go below zero, and the redemption value will not fall below what was already earned, so the bond itself does not lose face value.
How do you buy an I bond?
Electronic I bonds are bought directly from the Treasury through its online platform, and there is an annual purchase limit per person.
Is the interest on an I bond taxed?
It is subject to federal income tax but exempt from state and local income tax, and the federal tax can be deferred until redemption.
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