Justice due knows no boundries.Tel: 202-331-7900

Should You Include I Bonds in Your Investment Portfolio?

Inflation has been heating up and is expected to continue at least into the fall, possibly longer. Where does this forecast leave nervous investors? A well-balanced portfolio is often considered to be the best defense.

One hedge you might add to your mix is an investment in U.S. Series I bonds. After all, the “I” in I bonds stands for inflation. With that in mind, here’s the skinny about investing in these bonds and how they’re treated for federal and state tax purposes.

Investment Basics

Series I bonds are offered by the U.S. Treasury Department. They’re nonmarketable securities that aren’t available in any secondary market. In other words, you can only buy I bonds directly from Uncle Sam.

As with other U.S. Savings bonds, I bonds are backed by the full faith and credit of the U.S. government. Of course, there are no absolute guarantees — particularly in the investment world — but that’s about as safe an investment as you can find.

Although I bonds typically yield lower returns than other comparable types of bonds, they’re often prized because of their safety and protection against inflation risk.

How Is the Interest Rate Set?

The interest rate for I bonds is determined by combining a fixed rate locked in at the time of purchase and an interest rate based on inflation reflected by a Consumer Price Index (CPI). Interest is earned for 30 years or until you cash in the bonds — whichever comes first.

Special Tax Break for Qualified I Bond Holders

The interest on I bonds may be exempt from federal income if the funds are used to pay for qualified higher education expenses. This exclusion is available only if the following conditions are met:

  • You cash in the bond in the tax year for which you’re claiming the exclusion.

  • You pay qualified higher education expenses in the same tax year for yourself, your spouse or your dependents.

  • You don’t file your tax return for that year as a married person filing separately.

  • The bond owner was 24 or older before the bond was issued.

  • A child isn’t listed as co-owner of the bond.

You might benefit from this unique tax break if you buy I bonds this year and set them aside to help pay for a child’s future college education.

However, this special tax exclusion is phased out at relatively moderate levels. For 2022, the phase-out occurs between $85,800 and $100,800 of modified adjusted gross income (MAGI) for single filers (between $128,650 and $158,650 of MAGI for joint filers).

The Treasury Department updates the fixed rate every six months on the first business day of the months of May and November. While the inflation rates are also announced at the same times as fixed rates, inflation rate changes are applied every six months starting with the initial issue date. For example, if you purchase an I bond in September, the new inflation rate announced in November will be applied in March.

The current combined rate for I bonds, in effect through October 31, is 9.62%. For the six months prior to that, the rate was 7.12%. As inflation goes up, so does the interest rate for I bonds.

How Is a Purchase Made?

You can acquire I bonds in electronic form online through the TreasuryDirect program. Alternatively, you may use your federal income tax refund to purchase them in paper form.

The cost of an I bond is the same as its face value. For example, you’ll pay $50 to acquire a $50 bond. Then the bond increases in value as it earns interest. You can buy a bond online in virtually every denomination of $25 and above, but paper bonds are sold in only five denominations of $50, $100, $200, $500 and $1,000.

Finally, be aware that there are annual limits on purchases. The maximum amount you can buy electronically from TreasuryDirect is $10,000 per year; $5,000 for paper I bonds purchased with your tax refund. Therefore, in effect, you can buy up to $15,000 in I bonds each year.

Tax Basics

Generally, income from Series I bonds is subject to federal income tax, like other U.S. savings bonds and most securities. However, I bonds are exempt from any state and local taxes, so this gives them an edge over certain comparable bonds.

The interest income from I bonds may be reported to the IRS in one of two ways.

1. Cash method. With this method, tax is deferred until you redeem the bonds. So, if you wait 20 years until you cash in the bonds, you can postpone any tax liability until that time. This is the preferred method for most taxpayers.

The full amount of deferred tax on I bonds will be owed at the time they mature (assuming you haven’t cashed them in already). For instance, if you bought I bonds at their inception in 1998, you’ll owe tax when they mature in 2028 if you don’t redeem them first.

2. Accrual method. Here, you can elect to pay the tax annually even though you don’t receive any current interest. This is a viable option if the bond owner is in a relatively low tax bracket. For instance, if you want to buy I bonds in a young child’s name, you might choose this approach. It could result in a lower overall tax bill.

Important: If you use the accrual method for I bonds you acquire in 2022, you must continue to use that method for all I bonds you purchase in the future.

Final Thoughts

Before you buy I bonds, consider whether they make sense for you from both an investment and tax viewpoint. Review all the key factors so that you can make an informed decision.