Q: I recently heard that the U.S. Treasury is issuing savings bonds with an unusually high interest rate. Is that true? What’s the catch?
A: No doubt you are referring to Series I U.S. Savings Bonds, otherwise known as “I Bonds.” Between now and April 30, 2022, you can buy I Bonds with an annual interest rate of 7.12 percent. That’s an amazing interest rate for a Treasury bond, considering that two-year Treasury notes now trade at a 0.50 percent yield. As you can imagine, these high interest rates are attracting a lot of attention. But I Bonds are a little quirky, so it makes sense to spend a little time understanding how they work before rushing out to buy them.
I Bonds are designed to protect investors from inflation. They do this by paying an interest rate that is comprised of two parts: 1) a base rate that is set by the Treasury and is fixed for life of the bond, and 2) an inflation rate, which changes every May and November and is equal to the monthly changes in the CPI for the prior six months expressed as an annual rate. The two rates are combined into what the Treasury calls the composite rate. The current fixed rate is 0.0 percent; the current inflation rate is 7.12 percent. If inflation drops, so will the interest rate on I Bonds.
When you buy an I Bond, you pay the full face value of the bond to the U.S. Treasury. Every month, the U.S Treasury credits your account with interest on your bond equal to the composite rate times the principal value. Every six months, the accrued interest is rolled into your principal and the new principal begins earning interest at the new composite rate. For example, let’s suppose you invest $10,000 in an I Bond on November 1 with a composite rate of 7.12 percent. Every month for the first six months, the U.S. Treasury will credit your bond with interest of $59.33 ($10,000 x 7.12% x 1/12). After six months, your principal will be $10,356 (the original $10,000 investment plus $356 of accrued interest) and the Treasury will credit your account each month with the new composite rate times $10,356. This process will repeat every six months for as long as you own the bond.
Here are some other things you should know about I Bonds:
1) Individual investors are limited to buying no more than $10,000 of I Bonds in any given year.
2) There is no secondary market for I Bonds. You can only buy them directly from the U.S. Treasury, some banks and certain payroll purchase plans.
3) I Bonds have a stated maturity of 30 years, but you can redeem them any time after one year. Note that if you redeem within five years, you will forfeit the last three months of interest as an early redemption penalty.
4) I Bonds cannot be owned in your IRA or Roth IRA.
5) I Bonds produce no cash flow until they are redeemed. Prior to redemption, all interest is accrued and applied to principal.
6) Interest on I Bonds is exempt from state and local taxes, but it is subject to federal income tax. Investors have a choice about when to pay tax on their I Bond earnings. They either pay on an accrual basis or a cash basis. Accrual basis means they pay tax each year on the income they earn. Cash basis means they pay in the year they redeem their bonds. Most investors choose cash basis.
Despite their quirks, I think I Bonds make a lot of sense for a lot of people. In any case, it is hard to beat a 7.12 percent interest rate.
More on Medicare
Last week I wrote about the different parts of Medicare, including the Medicare Advantage plans. I received an email from a reader reminding me that our community has a wonderful resource to help Medicare beneficiaries navigate the complexities of Medicare open enrollment. Alliance on Aging provides comprehensive, individualized, and unbiased assessments regarding the benefits and costs of various Medicare insurance options—and it is all free. You can contact them at (831) 655-1334 or go to their website at AllianceOnAging.org.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.