By Jeremy Rivers, CFP®

As of November, the U.S. inflation rate for the year capped at 6.8%, which is the highest it’s been since June of 1982. With this exponential rise in inflation, Series I Bonds have received renewed attention.

What Are Series I Bonds?

I Bonds are a type of U.S. savings bond that earns interest by combining a fixed rate and inflation rate to protect the value of cash-based assets from inflation. Additionally, these bonds are exempt from state and local income taxes, making them a prime candidate for a low-risk investment.

What makes I Bonds different from other bonds is their interest rate structure. The composite rate is a combination of the fixed and inflation rates and is the actual rate of interest that an I Bond will earn over a six-month period. The formula for calculating the composite rate of an I Bond is:

[Fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]

As an example, let’s calculate the composite rate of I Bonds from November 2021 to April 2022. The current fixed rate is 0.00%, and the semiannual inflation rate is 3.56% based on the adjustments made every six months through the Consumer Price Index. After plugging these rates into the formula, we see that the composite rate for I Bonds from November 2021 until April 2022 is 7.12%.

Benefits of Series I Bonds

The reason this unique interest calculation is so beneficial is that it factors inflation into the composite interest rate. Instead of the bond’s purchasing power fluctuating with inflation like most other bonds, it stays anchored down by the semiannual inflation rate, leading to more consistent inflation-adjusted returns.

If these many benefits make you want to invest a load of money in I Bonds, hit pause. These types of bonds have three major drawbacks:

  • Investment limits.
  • Account restrictions.
  • Short-term redemption rules.

I Bonds have an investment limit of $10,000 per individual per calendar year. While there are a few ways to circumvent this limit, such as buying one bond on December 31 and another on January 1, the limit is generally inconvenient for most investors. It is important to note that you can purchase an additional $5,000 worth of Series I Bonds with your tax refund using Form 8888, Allocation of Refund.

Although it’s more of an inconvenience than a drawback, Series I Bond purchases cannot be made in Individual Retirement Accounts (IRAs) or Roth IRAs.

The last drawback is the penalties incurred for redeeming an I Bond prematurely. I Bonds cannot be cashed until one year after issuance. If they are cashed in the first five years of their maturity, the prior three months of interest are forfeited. Only if the bond is cashed after five years will the investor receive all interest benefits.

Series I Bonds Tax Considerations

Interest earned on Series I Bonds is exempt from state and local income tax but not federal income tax. When reporting the interest on your tax forms, there are a few different options. You have a choice. You can

  • Report the interest every year
  • Put off (defer) reporting the interest until you file a federal income tax return for the first year in which one of these events occurs:
    • You cash the bond and receive what the bond is worth, including the interest.
    • You give up ownership of the bond and the bond is reissued.
    • The bond stops earning interest because it has reached final maturity.

If you decide to report the interest every year, keep in mind that you will need to continue to do so each year for all the savings bonds you presently hold, as well as bonds you may acquire in the future.

Using Series I Bonds to Fund Higher Education

The Education Savings Bond Program allows Series I Bond holders to partially exclude interest made on an I Bond from federal income tax, making it nearly or totally tax-free. Here’s how it works: If you redeem a Series I Bond while also paying for higher education (undergraduate- or graduate-level schooling) at an eligible institution, the interest made on the bond is not a taxable part of your income.

The stipulations to this exclusion are:

  • The bond must be issued after 1989.
  • Must be held in the name of someone older than 24.
  • The holder’s modified adjusted income must be less than the cut-off amount set by the IRS.

The current cut-off amounts are $97,350 if single, head of household, or qualifying widow(er) and $153,550 if married filing jointly. If all those stipulations are met, you are eligible for the tax exclusion under the Education Savings Bond Program. This tax benefit also extends to holders of Series EE Bonds.

Series I Bonds vs. Series EE Bonds

The tax exemption surrounding education costs is one major similarity between Series I and Series EE Bonds. While these two types of bonds also have many other similarities, the main differentiator between the two is factoring in inflation. For a more comprehensive comparison of these two types of bonds, see the chart below:

EE Bonds vs I Bonds

Your financial advisor cannot purchase these in brokerage accounts, so if you want to buy Series I Bonds, visit the Treasury Direct website to make an account and invest. Have questions? Contact Stonebridge Financial Group’s offices in the Harrisburg or Lancaster area to learn more about bonds.