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?