If you weren’t around for it, I can describe the 1990s in a single word…
In the era of neon colors, Walkman, and Zima, American culture was highly saturated and blurred with a nostalgic glow of the rock-and-roll era that preceded it.
Boy bands… Rollerblades… Zack Morris phones… everything popped in the 1990s. And everyone was ready to party. Even the U.S. Treasury Department.
Yeah, that’s right, even the Treasury Department decided to ride the radical wave and introduce a financial sidekick that could keep up with the times.
They rolled out the red carpet for the new Series I bonds (or inflation bonds), a sleek and modern upgrade to those traditional savings bonds your folks might've stashed away.
Series I bonds are a type of official U.S. savings bond issued by the Treasury Department. They were introduced in 1998 as a savings instrument designed to provide investors with a safe way to preserve their money's purchasing power while earning a return.
What sets I bonds apart is their built-in inflation protection mechanism.
Unlike traditional fixed-interest investments, the interest rate on I bonds is made up of two components:
- A fixed rate.
- A variable inflation rate.
The fixed rate remains constant throughout the life of the bond. Meanwhile, the inflation rate is adjusted semiannually based on changes in the Consumer Price Index for All Urban Consumers (CPI-U).
Unfortunately, the bulk of the interest rate on I bonds is based on the adjustable inflation rate. Right now the combined fixed and inflation-adjusted interest rate is paying a 4.30% APY for Series I savings bonds. However, the fixed interest rate is only 0.90% APY.
Source: TreasuryDirect.gov
The variable inflation rate portion of the total right now is 3.40% APY. But, again, that rate is adjusted semiannually. The next adjustment takes place on October 31, 2023. And with inflation levels slowing coming down as per CPI-U, we should expect that variable inflation rate to fall.
The important takeaway here is to remember the fixed interest rate for I bond is only 0.90% APY. Even though the bonds are paying a 4.30% APY right now, it’s likely they’ll yield less come November.
Add to this that fact that there are penalties for cashing in I bonds in under five years of purchase and you’re better off keeping your money in a high interest-yielding savings account. Some banks have savings accounts that yield 4%–5% APY right now.
So why would anyone buy I bonds?
Well, there are a few minor tax advantages.
First, interest paid on I Bonds is exempt from federal tax. However, it’s not exempt from any state or local taxes. Interest paid from a savings account, on the other hand, is considered part of gross income and is subject to all taxes. So there’s a slight tax advantage to holding I bonds compared with a regular savings account.
Under certain conditions, interest from I bonds becomes completely tax-exempt when it's used to pay for higher education. The Treasury Department has a bunch of restrictions in regard to that tax exclusion, which you can see here. But the short of it is that if someone bought you an I bond when you were a kid and you used it to pay for college after high school, any interest earned would be completely tax-exempt — as long as you file property, that is.
And that’s what I bonds are seemingly intended to be: a simple way for parents, grandparents, aunts, uncles, other relatives, and friends to help pay for a kid’s future college expenses. It’s almost the equivalent of writing a post-dated check that will (hopefully) keep up with real inflation for a kid to use to pay for college in the future.
You’re certainly not going to become wealthy owning I bonds. There’s a total annual purchasing limit of $15,000. You can only purchase a maximum of $10,000 in electronic I bonds and up to $5,000 in paper I bonds (with your tax refund). So any profit or tax advantage from I bonds is pretty much negligible.
At the end of the day, I bonds offer a straightforward method for folks to help save for future college expenses with a unique combination of safety, inflation protection, and tax advantages. Their innovative interest structure sets them apart from traditional savings instruments. However, there are better options for higher returns and liquidity for college savings.
