Why Your Family Should Buy I-Bonds and Close Your Savings Accounts at the Bank

09/10/2012
By
UNITED STATED SAVINGS BONDS - NARA - 515924

War Bonds are similar to savings bonds (Photo credit: Wikipedia)

I have a top secret savings tip that I’ve used for years and it ensures I will always lose money. What I do is take savings and deposit it into an interest bearing account at the bank. With super low interest rates that banks pay, usually 1 percent or less, all I have to do is sit back and watch my money shrink as inflation eats it up. Whatever isn’t consumed by rapidly rising prices gets chewed up by my federal and state income tax rates. It’s so nice not having to worry about what to do with all that money.

However, I have a confession to make. Some time ago, I fell off the wagon. I left behind the safety of my continuously diminishing pile of cash and started using a new way to save. Unfortunately, it hasn’t worked out. If you are looking to erode your savings in a slow, painful manner, stick to bank accounts, because government I-bonds are not for you.

Why an I-Bond is better Than Bank Interest

I-Bonds are a government-backed security that can be purchased online in various denominations. Interest rates are pegged to the current rate of inflation so that you never risk losing savings to rising prices. Better still, since interest is paid by the federal government, it’s not subject to state income taxes. Federal taxes owed on your bonds can either be deferred until you exercise the bond or paid annually on your tax return.

Boilerplate explanation aside, interest rates are currently more than double most of the best savings/CD interest rates. Until October 2012, bonds are earning at a rate of 2.2 percent. This is an astronomical return for a safe investment.

Online buying, selling and access through Treasury Direct gives bonds a bank account feel. You can even setup your account so that your directly deposit savings into new bonds.

I-Bond Tax-Shifting is Awesome for Families!

Bonds are unique savings instruments because there are options to shift tax burden to other people. Depending on how you list the bond holder you can shift taxes onto someone you gift the bond to or you can gift the bond and keep the tax liability. You can also avoid paying taxes on bonds altogether buy using the proceeds of the bond to pay for college expenses.

When you earn money on a savings account, you owe taxes on the interest. Case closed. You can’t move that responsibility around.

Great, but Not Perfect

Here’s where I put my sales pitch to rest. When it comes to interest and taxes, I-Bonds are far superior to bank accounts. Of course superior benefits rarely come without a few catches. There are three limitations regarding I-Bonds that make them more of a challenge to use for saving.

You cannot redeem them for one year. The only exception to this forbearance is if you suffered from a natural disaster like a hurricane. The one-year redemption rule makes using I-Bonds more like a one-year CD and less accessible than a savings account.

The interest penalty for redeeming before 5 years, guarantees that you’ll lose a portion of the interest you save. However, the difference in interest payouts between bank accounts and I-Bonds is large enough that you are still better off with I-Bonds. Let’s assume that you redeem the bonds after one year at a 2.2 percent interest rate. After the three month penalty, your effective rate reduces to 1.65 percent. Still better than bank account interest rates. If you hold the bonds longer, the effect from the lost interest diminishes.

The last restriction on I-Bonds worth mentioning is that the federal government limits you to purchasing only $10,000 in I-Bonds each year. This isn’t a problem for most people, but if you do have a massive hoard of money you want to earn interest, you will not be able to save by I-Bonds alone.

How My Family Uses I-Bonds

My wife and I have a travel fund. In a few years we hope to make a big trip to Venice. Money is tight for us right now, so will be saving a little at a time for the next few years. I-Bonds are perfect for this type of saving and we will be better off than CDs, which was where I had wasted time and money for travel saving in the past.

Before my wife and I were married, I periodically saved money in I-Bonds for an engagement ring and our wedding. I’d actually held the bonds long enough to avoid the 5-year interest penalty. Interest earned during the period I held bonds were at least double what I would have been paid with a savings account or CD.

Part of our emergency funds is in I-Bonds and I hope to make it a greater proportion. This way your emergency money doesn’t erode in-between emergencies. Given the one-year restriction, it’s not wise to put your whole emergency funds into I-Bonds right away. Instead, you have to convert your savings over time.

What do you think? Are I-Bonds a superior alternative to bank accounts, or are rules and restrictions too cumbersome? Is it a bad idea to have your emergency funds in savings bonds?

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20 Responses to Why Your Family Should Buy I-Bonds and Close Your Savings Accounts at the Bank

  1. Lance@MoneyLife&More on 09/10/2012 at 8:58 am

    If you are in a decent financial position to be able to start to invest in these while still having cash available for emergency IRS it seems like a decent deal to me. You just have to be careful with the one year lock up period. How much were I bonds paying when savings account interest rates were 4 to 5%? Do you know?

  2. Jason on 09/10/2012 at 9:00 am

    Does the penalty go down the close to the 5 years that you get? For instance you mentioned the penalty was 3 months worth of interested if you cashed it out in 1 year. So, if you cashed it out in 3 years would there only be 1 month worth of penalties?

    Overall these aren’t too bad; the liquidity would really be the issue for me but it depends what you’re using the cash for. A long-term targeted savings is a pretty good fit.

    • John on 09/10/2012 at 2:04 pm

      from 0-1 year: no redemption
      from 1-5 years: loss of last three months of interest
      after 5 years: no penalty

      The 1 year wait is a hurtle, but I’ve also never used up my entire emergency fund savings. Anything sitting in the bank account has fallen behind my I-Bonds. Liquidity isn’t too bad. It’s bought and sold through the government and not the secondary market. You used to be able to cash the bonds at the bank like a check, but they don’t really use paper anymore. I foresee there being a day or two for funds to move from treasury direct to your bank account, but overall, it’s not an unreasonable amount of time to wait.

  3. Kurt @ Money Counselor on 09/10/2012 at 10:24 am

    I-bonds seem like a good option for at least a portion of one’s cash. I think I wouldn’t use them for an emergency fund; still stick with a bank account for that. Or maybe I’d keep half the emergency fund in the bank and half in I-Bonds.

    You mention the $10,000 per year purchase limit, but is there a limit on total holdings?

    How would you contrast these with something like the Vanguard Treasury Inflation-Protected securities mutual fund?

    • John on 09/10/2012 at 1:50 pm

      You definitely want to build up an account if you are going to use it for an emergency fund. Don’t go all in at once. I would also probably keep at least some cash on hand. But, it is fairly liquid. It’s too bad they did away with paper bonds. You used to be able to just cash them at the bank like a check.

      There is no total purchasing limit. Just the annual limitation.

      I-Bonds are completely different than the mutual fund you listed. I-Bonds are a saving vehicle and not an investment. There is no risk of losing principle; since its a Mutual Fund, there is a purchase and sell NAV and that could mean a potential loss even if fairly safe. As a mutual fund, there are annual fees that need to be paid. Since it’s a mutual fund, it is subject to capital gains taxes. I-Bonds have lots of tax benefits, mutual funds work like stock. The mutual funds would probably be a good income investment, but not something to put your safe spending into.

      I hope this helps.

  4. PK on 09/10/2012 at 10:54 am

    That capital gains tax on your bank account is a killer.

    Can you pay bills out of your TD account?

    • John on 09/10/2012 at 1:33 pm

      No beer may be purchased nor bill paid directly from your TD account.

  5. Shawn James @ PipsToday on 09/11/2012 at 2:54 am

    Definitely, I-Bonds are a superior alternative to bank accounts but not the best investment option. The rules and restrictions are not much complex and can be followed by people. I-Bond is a good option for those people who do not want to take risk with their saved money and prefer saving account.

    I think stock and forex is the best investment, if you want more profit on invested money in less time. Remember, Investment in stock and forex involved high risk.

    I think, emergency funds should be in saving account not in savings bonds?

  6. Eric on 09/11/2012 at 4:08 pm

    I have read about I bonds a handful of times, but never taken the plunge. The lack of liquidity is my biggest worry point. I have some government bond ETFs, so I roughly mirror the interest rate of a pool of different government debt types.

    • John on 09/11/2012 at 10:32 pm

      I’m not sure the liquidity is a big issue if you are careful to purchase small amounts over time. The important thing to remember about I-Bonds is that they are safe, predictable savings whereas an ETF is an investment.

  7. SB @ FPR on 09/12/2012 at 12:42 am

    This is good option to try out, thanks for the heads up. Half of my emergency fund can move to iBond. As per my calculation, even with 3 month’s interest penalty, my fund would earn me much more return than the CD/savings combination I have now.

    • John on 09/12/2012 at 6:09 am

      It has worked well for me this far.

  8. Harry @ PF Pro on 09/12/2012 at 2:01 am

    I bonds are a good choice, the 10k limit kind of sucks though! You can’t really lock in great rates when you can only do 10k a year. I personally go with Ally 5 year CD’s since there is only a 2 month interest penalty. I think I bonds are paying 2.2% right now??

    But I know a few people who locked in the i bonds 5-10 years ago and are getting 5% + right now..

    • John on 09/12/2012 at 6:06 am

      I’ll have to check out the Ally 5-year. However, you do want to be mindful of your state income tax rate. I’d have to run the math, but I-Bonds might still be the better after-tax option.

  9. [...] low interest rates are definitely hurting savers and unless you are buying I-Bonds, it’s wreaking havoc on your emergency savings. However, I’m curious as to whether savers are [...]

  10. femmefrugality on 09/15/2012 at 10:30 am

    I both like and hate that when you buy bonds now the interest rate is set for the entirety of the ownership. I know that’s how it works for EE bonds. It’s kept me from buying them as their interest rates have been so low. But apparently I bonds are much higher! We might have to look at doing our savings this way…

    • John on 09/17/2012 at 8:34 pm

      I-Bonds adjust every 6 months. That way it stays ahead of inflation.

  11. [...] banks pay squat these days in interest on CDs and savings accounts. John at My Family Finances recommends I-Bonds instead of bank accounts. He says interest rates on I-Bonds today are more than double the best [...]

  12. [...] Why Your Family Should Buy I-Bonds and Close Your Savings Accounts at the Bank by My Family Finances. [...]

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