I savings bonds

Series I Savings Bonds (often called I Bonds) are government savings bonds issued by the U.S. Treasury that offer inflation protection. I Bonds offer tax-deferral for up to 30 years and are free from state and local taxation. I Bonds are not marketable securities and cannot be traded in the secondary market.

Note: Treasury Inflation Protected Securities (TIPS) also provide inflation protection. TIPS are considered alternatives to I Bonds. See I Bonds vs TIPS for similarities and differences between the two instruments.

History
I bonds were first issued in September, 1998. Historical interest rates, along with computation metrics, for I bond issues can be found at TreasuryDirect.

Composite rate
I Bonds have two components that make up their composite rate (total yield): a fixed rate and an inflation rate.
 * The fixed rate is fixed for the entire life of any given I Bond. The fixed rate for newly-issued I Bonds is announced on May 1 and November 1 of each year, and applies to all I Bonds issued during that six month period.
 * The inflation rate is based on the Consumer Price Index and is also announced every six months, on May 1 and November 1. The May rate is based on the change in the CPI-U from the previous September to March and the November rate on the change from March to September. This inflation adjustment applies to both existing I Bonds and newly-issued ones, but the timing of that adjustment is dependent on the original issue date of any particular I Bond.

The composite rate can never go below zero, which protects investors in times of deflation.

Interest accrues monthly and compounds semiannually.

Six-month cycle of composite earnings rates
I Bond interest is calculated in six month cycles, based on the original date of issue. Each I Bond's composite rate (fixed and inflation) remains in effect for a total of six months, and then changes to a combination of that I Bond's fixed rate plus the most recently announced inflation adjustment for the next six months. That cycle continues for the life of an I Bond:

An example of the composite rate calculation using I bonds issued May 2009 - Oct. 2009:


 * Given a Fixed rate = 0.10% and a Semiannual inflation rate = -2.78%


 * Composite rate = [Fixed rate + (2 x Semiannual inflation rate) + (Fixed rate x Semiannual inflation rate)]
 * Composite rate = [0.0010 + (2 &times; -0.0278) + (0.0010 &times; -0.0278)]
 * Composite rate = [0.0010 + (-0.0556) + (-0.0000278)]
 * Composite rate = [-0.0546278]
 * Composite rate = -0.0546
 * Composite rate = -5.46%
 * Composite rate = 0.00% (Composite rates are never less than zero)

How the formula works
If the inflation rate during the six months the composite rate applies is the same as the inflation rate from the previous period used in the computation of the composite rate, the pre-tax real return is the fixed rate. Example: assume a fixed rate of 1% and a semi-annual inflation rate of 1.5%. The composite rate = [.01 + (2 &times; .015) + (.01 &times; .015)] = .04015. After six months, $1 invested in the I bond is worth


 * (1 + .04015/2) = 1.020075, and what used to cost $1 now costs 1.015 after inflation.

Before, $1 would buy 1.0 item that cost $1. Now you have $1.020075, but the item now costs $1.015. You can now buy


 * 1.020075/1.015 = 1.005 items, 0.5% more than before.

Your real return for the six months is 0.5%. This produces an annual real return of 1.0% (the fixed rate), compounded every six months (the actual real return after one year is greater than 1.0% because of the compounding).

How interest is calculated
All bond values are based on the $25 bond. A $5000 bond is worth 200 times what a $25 bond is worth; a $100 bond is worth 4 times what a $25 bond is worth. If you have a $80 electronic bond at TreasuryDirect, it is worth 3.2 $25 bonds. The $25 bond value is always rounded to the nearest penny. Thus, a $5000 bond must always have a value that is a multiple of $2.00.

Interest is computed on a $25 bond using the composite rate divided by 2 for the given six month period. For individual months within the six month period, interest is computed using pseudo-monthly compounding to produce the same result after six months. For example, if the composite rate is 2.57%, the bond value after


 * 1 month is $25 &times; (1 + 0.0257/2)^(1/6) = $25.05, and after
 * 4 months is $25 &times; (1 + 0.0257/2)^(4/6) = $25.21, and after
 * 6 months is $25 &times; (1 + 0.0257/2)^(6/6) = $25.32.

The values of a $100 bond would be $100.20, $100.84, and $101.28 after those same time periods. Note that this ignores the 3 month penalty for redemption within the first 5 years and the restriction on redemption within the first year.

Current interest rates and I Bond value
To find out the current interest rate of I Bonds and the worth of your bonds, the following resources of TreasuryDirect may be used:
 * I Savings Bonds Rates and Terms
 * Savings Bond Calculator
 * Savings Bond Wizard

Purchase


Both paper and electronic versions of I Bonds are available. Each version is limited to $5,000 per person per year. (Investors can also purchase an additional $5,000 in paper bonds and $5,000 via TreasuryDirect for their trust.) I Bonds are sold at face value; for example, you would pay $100 for a $100 I Bond. I Bonds are not marketable securities, meaning that, unlike other bonds and stocks, you cannot trade I Bonds in the secondary market.
 * Electronic I Bonds - You can buy electronic I Bonds at TreasuryDirect. Purchases may be made in amounts of $25 or more, to the penny.
 * Paper I Bonds - Paper I Bonds may be purchased in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000. Bonds may be replaced if they are lost, stolen, mutilated, or never received. You can buy paper I Bonds at any bank that's an agent for the Federal Reserve (most are).  If you are not able to buy I-bonds locally (such as if you only bank online), you can also mail your completed I Bond purchase paperwork and payment directly to the Federal Reserve Bank (enter your zip code on the TreasuryDirect Retail Securities Site Locator to find the mailing address). I-bond purchase order forms can be ordered by mail.

Purchase With Your IRS Tax Refund
New for 2009 tax filing: If you are receiving a federal tax refund from the Internal Revenue Service, you can choose to use that money to purchase up to $5,000 in U.S. Series I Savings Bonds. Previously, you could only direct the refund to an existing TreasuryDirect account to be used for the purchase of electronic securities. Now, you have both options. No TreasuryDirect account is necessary.
 * 1) The total amount of saving bonds purchased must be a multiple of $50. Additional money over the specified amount must be deposited into another financial account – such as a checking or savings account.
 * 2) You will receive the U.S. savings bonds in the mail.
 * 3) You normally select this option by filing Form 8888, Direct Deposit of Refund to More Than One Account.

In the 2010 tax filing season (when you file your taxes for 2009) bond registrations using this purchase method will be based on the filing status shown on your return. If the filing status is "Married Filing Jointly," the bonds will be registered in co-ownership form (e.g., John Doe or Mary Doe). For any other filing status, the bonds will be registered in single owner form. Gift and beneficiary registrations may be available beginning in 2011.

In the 2010 tax filing season (when you file your taxes for 2009), bonds purchased using this method can be issued only in your own name or, if you and your spouse file your return as "Married Filing Jointly," in both spouses' names.

Beginning in the 2011 tax filing season, you may have more choices that allow you to buy bonds in the joint names of yourself and a co-owner, such as a child or grandchild.

Redemption
I Bonds cannot be redeemed during the first year, and if you redeem them within the first five years after purchase, you lose the most recent three months' interest. When you redeem your I Bonds, you can never get back less than you invested, even if there was a long period of negative inflation (deflation).

Tax-deferred growth
Interest from I Bonds accumulates tax-deferred for up to 30 years. (I Bonds do not distribute interest like CDs and other bonds do.) After 30 years, the I Bonds no longer earn any additional interest. When I Bonds are redeemed, the interest is taxable income for federal income tax purposes, but is free from state and local taxation. However, if the entire proceeds of the I Bond redemption (both principal and interest) are used for qualifying educational expenses, the interest can be tax-free at the federal level (see below). You also have the choice of paying income taxes on the accrued interest each year (which may be advantageous if a bond is titled in a child's name). If you choose the annual tax payment method you must continue with this method for the entire remaining life of the bond.

Tax-free growth for Qualified Education Expenses
If I Bonds are redeemed for qualifying education expenses, the interest is completely tax free, provided certain conditions are met. According to Publication 970 (2009), Tax Benefits for Education, the tax-free redemption requires the following conditions to be met:


 * You pay qualified educational expenses for yourself, your spouse, or a dependent for whom you claim an exemption on your return.
 * Your modified adjusted gross income (MAGI) is less than $84,950 for single taxpayers ($134,900 if married filing jointly or qualifying widow(er)). The amount of your interest exclusion is gradually reduced (phased out) if your modified adjusted gross income is between $69,950 and $84,950 (between $104,900 and $134,900 if your filing status is married filing jointly or qualifying widow(er)). You cannot exclude any of the interest if your modified adjusted gross income is equal to or more than the upper limit.The phaseout, if any, is figured for you when you fill out Form 8815. The MAGI numbers are adjusted annually.
 * Your filing status is not married filing separately.
 * The owner of the Savings Bonds must be at least 24 years old before the bond's issue date. (The issue date is printed on the front of the Savings Bond.)
 * The full proceeds of the savings bond redemption (both interest and principal) must be used for qualifying educational expenses.

Note that redeeming I Bonds to contribute to a 529 plan or a Coverdell education savings account is also considered a qualified educational expense. To take advantage of this, file IRS Form 8815 to claim an exclusion for the interest after rolling the proceeds of these US Savings Bonds into a section 529 college savings plan or Coverdell Education Savings account. Write "529 College Savings Plan" or "Coverdell Education Savings Account" in the answer to 1(b), where it asks for the name of the educational institution. See Publication 970 (2009), Tax Benefits for Education for more details.

2009 Modified AGI Limits
For all other filing statuses, your interest exclusion is phased out if your modified AGI is between $69,950 and $84,950. You cannot take the exclusion if your modified AGI is $84,950 or more. For more information, see chapter 11 in Publication 970, Tax Benefits for Education.

Role in a portfolio

 * If your tax-advantaged accounts are filled up with bond funds, you can "extend" your tax-advantaged accounts by purchasing I Bonds in your taxable account. This process is somewhat similar, but not identical, to placing Treasury Inflation Protected Securities in your Non-deductible Traditional IRA.  Buying I Bonds in your taxable account is particularly useful if your tax bracket is too low to justify owning tax-exempt bonds in your taxable account.
 * If you are desperately looking for tax-advantaged space to hold tax-inefficient assets like REITs, you can free up some of your tax-advantaged space by purchasing I Bonds in your taxable account and then exchanging a part of the bond allocation in your tax-advantaged account to a REIT fund.
 * If you have a tax-free growth account like a Roth IRA, but no tax-deferred account like a Traditional IRA, you may want to place stocks in the Roth IRA while buying I Bonds in your taxable account to make the maximum use of the tax-free growth in the Roth IRA.
 * I-bonds older than 1 year can serve as an emergency fund if you can absorb the 3-month interest penalty; otherwise I-bonds at least 5 years old serve as an emergency fund just fine. The yield can at times be higher than money market funds or bank savings accounts.

Redemption while in a high tax bracket
I Bonds redeemed when the investor is in a high tax bracket may provide little or no positive after-tax, after-inflation return, especially if they are held for shorter periods of time. For this reason, if you expect to be in a high tax bracket when you redeem your I Bonds, they may not be a suitable investment for you. Specifically, if you are in your 20s, in 30 years you may well be in your peak earning years, which means you would probably be in a high tax bracket when the bonds mature.

To illustrate the point, here is the after-tax, after-inflation value of $1 invested in I bonds compounded for 30 years (60 semi-annual periods) with 3% inflation and a 1% fixed rate and then redeemed in the 35% federal income tax bracket:


 * (1 + ((1 + 0.04015/2)^60 - 1) &times; (1 - 0.35)) / (1.03^30) = $1.02671191
 * where 0.04015 is the composite rate (.01 + (2 &times; .015) + (.01 &times; .015) = .04015) and 0.0415/2 is the rate that is compounded every 6 months (60 times in 30 years)

This is equivalent to a real after-tax return of 0.088%/year.

Tips for buying I Bonds
Since I Bonds earn the full month's interest if you own them on the last day of that month, it is generally a good idea to buy I Bonds at the end of a month after also earning interest on that same money in a bank account during most of that same month. Conversely, you would want to redeem your I Bonds at the beginning of any month, since holding them until later in the month will not earn any additional interest, unless you own them on the last day of the month.

Buying paper I bonds at a bank
Buying paper I bonds at a bank can be quick and easy, or it can be frustrating.


 * When talking to bank staff, call them "savings bonds," not "I bonds." When you are sure you are talking to a staffer who knows how to sell savings bonds, call them "Series I savings bonds."


 * If you don't have an account at a bank that sells I bonds, it is probably easiest to avoid the banks and buy them directly from the Treasury, using the mail-in order method explained here and accessed here.


 * Phone ahead. Even if the bank does sell them, not everyone at the bank may know it. Be sure someone who knows how to sell them will be there when you come in. Your chances may be better on a weekday when senior staff is available.


 * It's basically a cash purchase. You will need to have a checking or savings account, or some kind of account that allows cash withdrawals. The account should have a high enough "available balance" to cover the I bonds you are buying. If you need to transfer money into the account in order to make the purchase, make the transfer several days ahead of time.


 * Typically, the bank gives you a one-page order form, the kind of carbonless form that makes several copies. You fill it out, you hand the staffer the form and a check or a withdrawal slip. The staffer accepts the payment, enters it into their system, stamps the form paid, and gives you one of the copies as a receipt. If the bank is a Federal Reserve agent, your purchase is complete. The issue date of the bonds will be the day the bank accepted the payment. When all goes well, you can be in and out in ten minutes. You get the printed paper bonds in the mail a week or two later.