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Inflation is up, the stock market is down, and I bonds have suddenly come into vogue due to an unprecedented interest rate of 9.62%. But while I bonds can help protect your savings from inflation, that doesn’t mean they’re right for everyone.
What are I bonds?
I bonds, also known as Series I savings bonds, are a form of bond that earns interest from a variable semiannual inflation rate based on changes in the Consumer Price Index for All Urban Consumers, or CPI-U. An I bond’s rate combines two different rates: a fixed rate and an inflation rate. The fixed interest rate remains the same throughout the bond’s life. Its inflation rate is announced by the Bureau of the Fiscal Service and can change twice a year, in May and November.
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The combination of an I bond’s fixed rate and inflation rate creates its composite rate. This is the interest rate an I bond will actually earn. Currently, I bonds are offering a composite rate of 9.62%.
As its name suggests, an I bond’s inflation rate is heavily impacted by inflation. As inflation changes, the inflation rate adjusts to offset those changes. This can help protect your money’s purchasing power.
And while that 9.62% I bond rate is making a splash in the news now, it may change in six months when the new inflation rate is set. You’re also required to hold your bond for at least a year before you can cash it in, and there are interest rate penalties for cashing in before five years.
How much money can you make with I bonds?
Say you bought $10,000 worth of electronic I bonds in May 2022 (the maximum amount of electronic I bonds you can buy in one year). Your fixed rate would be 0% and your inflation rate would be 4.81%. Your composite rate would be calculated as follows:
[Fixed rate + (2x inflation rate) + (fixed rate x inflation rate)] = composite rate
[0 + (2 x 0.0481) + (0 x 0.0481)] = 0.09620
This composite rate of 9.62%, applied to $10,000 in I bonds, would earn a guaranteed $481 in interest over the next six months — but you cannot cash in your bond until you’ve held it for a year. So why even mention the six-month take? Because your rate is only guaranteed for six months. After that, the rate can go up or down.
Assuming interest rates stay the same as they are now, and after adding your first six months of interest ($481) to your principal of $10,000, you could earn $985 total in interest after one year. But if you cash in your bond before you’ve held it for five years, you’ll lose the last three months of interest you earned. If the rate stays the same, that would mean you’d subtract $252 from your interest and exit the bond agreement with your $10,000 in principal and $733 in interest for a total of $10,733, minus any tax owed.
But bonds are meant to be held long term, and rates likely will change over time. If you kept your $10,000 bond for 30 years, you wouldn’t lose any interest to penalties, but there is no guarantee your rate would stay the same. This can make it difficult to know exactly how much you can make investing in I bonds over a long period — though that is true for most investments.
I bond considerations
I bonds aren’t just a free for all — they’re government-backed bonds. Here are some of the important things to keep in mind:
Types of I bonds
There are two types of I bonds, paper and electronic.
Paper I bonds can only be purchased by mail when filing a federal income tax return. This alone can make it difficult to purchase them. They have a minimum purchase amount of $50 and a maximum of $5,000 per calendar year. You can buy them in increments of $50, $100, $200, $500 and $1,000.
Electronic I bonds can be purchased online. They have a minimum purchase amount of $25 and a maximum of $10,000 each calendar year. You can buy them in any amount up to $10,000.
If you buy the maximum amount of paper and electronic I bonds, you can buy up to $15,000 worth of I bonds each year.
How long to keep I bonds
“Most bondholders hold the bond for at least 12 months. If they sell the bond before the 12 months, they receive no interest,” Clark Kendall, a certified financial planner and founder of Kendall Capital in Rockville, Maryland, said in an email interview. “If they sell a bond after holding it for less than 5 years, they lose 3 months of interest on the bond.”
If you hold the bond for five years or more, you won’t lose any interest. I bonds can earn interest for 30 years unless you cash them out before then.
I bonds and taxes
The interest you earn from I bonds is subject to federal income tax but not state or local income tax.
An education tax exclusion can help you exclude all or part of your I bond interest from your gross income if you meet several conditions, including paying for qualified higher education expenses in the same tax year.
Should you buy I bonds?
I bonds are everywhere in the news right now, but does that mean they’re worth it?
“I bonds are a good place to park some cash that you will need in the intermediate term (one to five years). For example, placing cash in I bonds that you will use for a down payment in a couple of years makes a lot of sense,” said Kenneth Chavis, a certified financial planner and senior wealth manager at LourdMurray in Los Angeles, in an email interview.
If you’re investing for a long time frame — for example, for retirement — you may want most of your portfolio allocated toward stocks instead. You can think of dipping stock markets as a sale. Keeping money invested in a volatile market is generally a sound strategy — historically speaking, odds are good your investments will rebound.
“There is a lot of talk about I bonds because of the current six-month rate, but at the end of the day, these investments should only be a small portion of a more robust investment portfolio,” said Kendall.
Disclosure: The author held no positions in the aforementioned investments at the original time of publication.