economics

January 31, 2010

The ABCs Of Risk-Free I Bonds

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Mel Lindauer, 01.29.10, 02:00 PM EST

How to buy, redeem and get the highest return from U.S. Treasury inflation protected bonds.

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Mel Lindauer

In my previous column I provided an introduction to I Bonds and discussed some of their many benefits, including:

1. They’re risk free.
2. They’re tax deferred.
3. They’re very flexible.
4. They’re free from state and local taxation.
5. They offer inflation protection.
6. They offer a “put option.”
7. You can’t lose money.
8. Even in deflationary periods, you never lose the interest you’ve previously earned.

Now let’s explore the mechanics of purchasing and redeeming I Bonds and talk a bit about how they work.

Purchasing paper I Bonds.

You can purchase paper I Bonds simply by filling out the proper form (available at most banks) and providing the bank with the paperwork and the funds, which are expected to be on deposit at the bank. The bank will provide you with a dated receipt copy and you’ll receive the I Bonds in the mail from the Federal Reserve in about two to four weeks. Regardless of how long it takes the Federal Reserve to process your paperwork and get the I Bonds out to you, as long as your bank is an agent for the Federal Reserve (most commercial banks are, but you’ll want to make sure before buying) your issue date will be the month you purchased them at the bank. (I Bonds only carry a month and year for the issue date.)

Purchasing electronic I Bonds.

You must first open an individual account at TreasuryDirect.gov and link it to your bank account. Once your account is open, you can then make your purchase online and the Treasury will deduct the purchase price from your linked bank account.

Purchase limits.

There is an annual purchase limit of $10,000 in I Bonds per Social Security number. To reach that limit you must buy both paper and electronic I Bonds, since each has a separate $5,000 limit. A married couple could, therefore, purchase a total of $20,000 per year in I Bonds, provided they buy both paper and electronic bonds.

Avoiding probate.

I Bonds don’t qualify for a step-up in cost basis at one’s death as many other investments, such as stocks and real estate, do. (I Bonds are like bank-CDs in that regard.). That means there is no tax advantage to titling I Bonds only in one name. But you can title them in such a way so as to avoid having them included in your estate subject to probate—by having either a second co-owner or a beneficiary listed on your I Bonds.

How I Bonds work.

When I Bonds are issued, they contain an “Issue Date” which is the month and year of purchase. In my previous column I explained that there are two components (a fixed interest rate and an inflation adjustment) that make up the total yield, or composite rate, for each I Bond issue date. The fixed interest rate of an I Bond remains the same for the 30-year life of the bond, but the inflation-adjustment figure and the fixed rate for newly purchased I Bonds are announced twice each year, on May 1 and Nov. 1. Each I Bond goes through six-month cycles based on its issue date, and on the six- and 12-month anniversaries of its issue, the rate is adjusted based on the original fixed interest rate and the latest announced inflation adjustment. Adding these two figures together determines the new composite rate the previously issued I Bonds earn for the next six months. This cycle repeats for the life of the I Bond.

Redeeming paper I Bonds.

Simply take your paper I Bonds to your bank, sign the back and the bank will credit your account just as if you had deposited cash. The funds will normally be available to you the following day. You could also receive cash.

Redeeming electronic I Bonds.

You can redeem your I Bonds (or any portion of your bond holdings, so long as you leave at least $25 in your account) using your online account. The money is then transferred into your linked bank account.

Timing your trades.

It’s important to know how and when I Bond interest is credited to your account in order to maximize your return. Interest is earned on the last day of each month and is posted to your account on the first day of the following month. So, if you own your I Bonds on the last day of any month, you’ll earn that full month’s interest. Therefore, it’s best to buy your I Bonds near the end of the month, since you can earn a full month’s interest while only owning the I Bonds for perhaps a day or two. On the other hand, when redeeming I Bonds, you’ll want to do so on or near the first business day of the month, since redeeming them later in the month won’t earn you any additional interest.

Understanding how I Bonds work is important since it can mean more money in your pocket. In the next column, I’ll talk about using I Bonds tax-free for qualifying educational expenses and about free software that can help you track the value of your I Bonds.

Mel Lindauer, CFS, WMS is one of the founders of the Bogleheads community and co-author of The Bogleheads’ Guide to Investing, along with Taylor Larimore and Michael LeBoeuf. He is also co-author of The Bogleheads’ Guide to Retirement Planning, along with Taylor Larimore, Richard Ferri, and Laura Dogu.

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