Buying Tax Free I-Bonds:

Savings vs Investing and Inflation

SEP IRA Retirement Savings

Copyright 2013 by Morris Rosenthal

All Rights Reserved

The Difference Between I Bonds and TIPS

The U.S. government offers two financial products for savers and investors who are primarily worried about future inflation eating their nest eggs. The first product is an inflation protected version of the classic savings bond, known as the I Bond. There are only two ways to purchase I Bonds, through the website or through tax refunds, and in both cases, the amount you can purchase in a calendar year is limited.

The second type of inflation protected product available through the U.S. government is TIPS (Treasury Inflation Protected Securities), which behave very differently than I Bonds. TIPS can be purchased through TreasuryDirect, through brokers, through mutual fund ownership or ETFs (Exchange Traded Funds). You can even take a short position on TIPS (betting that the price will fall) if that's your style.

The most important difference between I Bonds and TIPS for many savers is how you cash out if you need the money before the ultimate maturity date. At the risk of oversimplifying, you can't lose money on I Bonds but you can lose money on TIPS. The reason is that I Bonds are not market securities that can be bought and sold through brokers. If you need to cash-in or partially redeem I Bonds before their maturity date of 30 years from the purchase date, you can do so any time after the first year, and the Treasury will pay you at minimum what you spent on the I Bond, even if they have to print the money to do so!

If you need to cash in TIPS before maturity, you have to sell them (or your TIPS fund shares) on the open market where the price is what buyers are willing to pay. This is true even if you buy TIPS through TreasuryDirect, the Treasury will not redeem them before maturity. You can transfer TIPS from a TreasuryDirect account to a broker and sell them, but it's non-trivial procedure since it involves filling out a form that requires the signature of a bank officer. And the market price for TIPS, as with all non-savings bond securities, can drop radically in a short time.

A 30 year TIPS issued auctioned by the Treasury at the beginning of 2013 year lost nearly 20% of its resale value just 4 months later when the issue was reopened, simply because the market believed the Federal Reserve was nearing the end of their quantitative easing campaigns. If you hold TIPS to maturity, the Treasury will redeem them for a minimum of the face value, even if there's been three decades of deflation, but 30 years is a long time to wait if you need the money today. The difference in auction prices for the 30 year TIPs just mentioned are highlighted with a red box, and the current value on the secondary market (through bond brokers) is even lower.

The tax treatment of I Bonds and TIPS is also radically different. I Bonds have no tax liability until they are cashed in, so the interest and inflation adjustments compound tax free. The interest on TIPS is paid to the holder twice a year and taxed in that year, so it doesn't compound for the long term. The inflation adjustment on TIPS principal is also taxed in the year it is made, but it isn't paid out, so the TIPS principal at maturity includes the cumulative effect of the adjustments. There are also capital gains liabilities with TIPS purchased at a discount in the secondary market.

Some TreasuryDirect Basics

We've already referred several times to TreasuryDirect, the U.S. Treasury website ( - remember the ".gov") for selling bonds and securities to individuals and financial institutions. It's free to set up your own TreasuryDirect account, but you do need a bank account for transferring funds. Your social security number and an email address are required, along with your bank account number and the routing number of the bank. The numbers can be obtained from the bottom of any check from your checkbook, or if you don't have a checkbook, you can stop by your bank and ask.

I opened an account with the Treasury over a decade ago and it's one of the smarter things I've done. Keep in mind it's not limited to I Bonds, you can also buy TIPS, non-inflation protected notes, bonds, and short term bills, with terms lasting 4 weeks to six months. Prior to the recession, T-Bills paid interest rates comparable to bank CDs with far less hassle. And if you own any old paper savings bonds, you can use your TreasuryDirect account to convert them to electronic bonds.

It takes a little time to get used to navigating the TreasuryDirect site through their menus. You cannot use the standard browser control arrows to go forward or back a page in TreasuryDirect. If you forget and use the browser's Back button, you'll get a page expired message and find you have to log in again, which can be a convoluted process due to security. Allowing TreasuryDirect to "register" your computer (drop a cookie) will save the step of needing to check your e-mail for a one-time code every time you log in, but you'll still have to peck out your password on their virtual keyboard:

Any TreasuryDirect page that comes at the end of a chain of actions, like a report on a single security, will include a Return button at the bottom to go back one page. Or, you can always use the menu bar at the top of the page to navigate to a different section of the site.

The Treasury does not function as a bank, meaning they pay no interest on any balance in your account which isn't invested in securities. That balance is kept in the fancifully named Zero-Interest C of I (Certificate of Indebtedness), which always appears in the payment options menu when you purchase new securities. You can transfer money directly from a linked bank account into your C of I, or you can designate the C of I to receive funds from interest payments or redemptions. You can tell TreasuryDirect to automatically fund purchases from your bank account, so maintaining a C of I balance isn't necessary. But if there's ever a problem making a transfer to a linked bank account, such as the account being closed or a bank refusing a transfer from TreasuryDirect, the money will be credited to your C of I instead. If you try to purchase a bond with money from your C of I that doesn't exist, the transaction simply will not go through.

How I Bonds Work

I Bonds are a 30 year savings bond product, which means they cease to pay interest after 30 years. The interest on I Bonds is free of local and state taxes, and if you use the proceeds for education, the interest may be free of federal taxes as well. The most important difference between I Bonds and the better known EE savings bonds is that the interest rate paid on I Bonds includes an inflation protection component that is updated twice a year. An odd fact that many people are unaware of is that the Treasury guarantees an EE Bond held for 20 years will double in value, regardless of the interest rate, through a special one-time adjustment. So EE Bonds held for just over 20 years may well pay more than I Bonds held just over 20 years, but if you need to cash that EE Bond even just one day early, you'll be very unhappy with the comparison.

Before looking at how interest is calculated and accrued, let's list the most important properties of I bonds:

Inflation protection - The value of the bond will never drop from one compounding period to the next, even in the case of deflation. The worst performance you will ever see from an I Bond is a period with no gains.

Tax deferred - There are no tax liabilities on I Bonds until you redeem them. So I Bonds can be used for retirement planning or as a tax management tool for people with irregular income, such as the self employed. This allows for tax-free compounding of the interest earned, and the bonds can then be cashed in a low income year to minimize taxes, which are paid at your federal income tax rate.

Tax exemptions - I Bond interest is exempt from state and local taxes at redemption, and if the proceeds are used for education, may also be exempt from federal income tax. For you to get the federal income tax exemption when using an I Bond for a child's education, you or your spouse must own the bond. The child may be registered as a beneficiary of the bond, but not as a co-owner.

Redemption - I Bonds cannot be redeemed for one year following the date of purchase. From the beginning of the second year through the end of the fifth year, I Bonds can be redeemed in full or in part, but there is a three month interest penalty, just as with most bank CDs. After five years of ownership, I Bonds can be redeemed in full or in part with no penalty. Note that the value of I Bonds less than 5 years old as displayed by the popular Savings Bond Calculator available from the Treasury shows the actual amount you would receive if redeeming on that day, they don't include the last three months interest.

Compounding - The earned interest is added to the principal on the first day of each month, and is compounded semi-annually on the six month anniversary after the purchase date. So it's slightly advantageous to redeem your bonds near the beginning of the month rather than the end.

Purchase limits - Up to $10,000 per social security number per year through TreasuryDirect, up to $5,000 as a paper bond through a tax refund.

Ownership options - As a Savings Bond product, I Bonds can be purchased for Sole Ownership, Co-ownership, or have a Beneficiary assigned. Savings bonds are not transferable by private sale or available in the secondary market.

Calculating Interest For I Bonds

The interest rate for I Bonds is calculated by combining a fixed interest rate, set when you purchase the bond, and the inflation rate based on the CPI-U. The Treasury announces both a new fixed rate and a new inflation rate twice a year, so that I Bonds issued between May 1st and Oct 31st of a given year all carry the same composite interest rate, and I Bonds issued between the following Nov 1st and April 30th share a different composite interest rate. Since November 2010, the fixed interest rate has been zero percent, so that the combined rate consists of the inflation component only. The formula for determining the combined, or composite rate is:

Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate)]

The fixed rate is expressed as an annual interest rate, and as previously mentioned, has been zero percent in recent years. The fixed rate doesn't change for the life of the bond, so people who bought I Bonds many years ago when the fixed rate was 3% got a much better deal than people who buy I Bonds today. The semiannual inflation rate is based on the prior six months of inflation as reported by the CPI-U, and is updated by the Treasury on the first business day of May and November. The graph below shows the CPI-U as reported for the last decade:

The interest rate earned by your existing I Bonds does not update instantaneously to the new rate, but waits for the next six month anniversary of the bond's original purchase month, and updates on the first day of that month.

At the current fixed rate of 0.0%, the composite rate is simplified as follows:

Composite rate = [ 0.0 + (2 x semiannual inflation rate) + (0.0 x semiannual inflation rate)]


Composite rate = 2 X semiannual inflation rate

Keep in mind that both the inflation rate and the fixed interest rate are changed from percentages to decimals when used in the formula, shifting the decimal point two spots to the left, or dividing by a hundred. So the composite rate for new I Bonds sold between May 1st through Nov 1st 2013 using the semi-annual inflation rate of 0.59% established on May 1st is:

Composite rate = 2 X .0059 = 0.018 = 1.18%

It's important that I Bonds treat the inflation adjustment as part of the composite interest rate (currently the whole thing) rather than as an adjustment to principal because interest is compounded. Keep in mind that the 2X is because the composite rate is expressed as an annual rate, even though it's only in effect for a half a year. They do it this way for the sake of comparison, since people are used to thinking of interest rates in terms of an annual rate.

Just for the sake of example, we'll calculate the composite rate with an arbitrary semiannual inflation rate and a nonzero interest rate. If the semiannual inflation rate next year at the time we do this theoretical calculation is 1.25% and the fixed rate is 1%, the composite rate would be:

Composite rate = [0.01 + (2 X 0.0125) + (0.01 x 0.0125)]


Composite Rate = [0.01 + 0.025 + 0.000125] = 0.035125 = 3.5125%

So even when the fixed rate is non-zero, the third part of the equation, which multiplies the fixed rate with the semiannual inflation rate, doesn't add much kick. Also note that when the fixed rate does rise, it may make sense to sell the I Bonds you own that pay a lower or zero fixed interest rate, and purchase new I Bonds at a higher fixed rate. You'll take a small hit having to pay federal income tax on the accrued interest to that point, and if the bonds are less than five years old, the three month interest penalty. But the purchase limits of $10,000 buying through TreasuryDirect plus $5,000 through a tax refund still apply, so selling and repurchasing I Bonds to get a better interest rate can take some years, and prevents you from building a larger position if you have the cash to do so.

How To Purchase And Redeem I Bonds

As mentioned earlier, there are only two ways to purchase I Bonds. You can buy up to $10,000 a year per social security number of electronic I Bonds through TreasuryDirect, and you can buy up to an additional $5,000 a year in paper I Bonds through your tax refund by filing a Form 888 - Allocation of Refund. The form is linked below:

Purchasing through a tax refund is the only way to obtain any paper savings bonds from the U.S. government today, and I Bonds are the only type available.

Within TreasuryDirect, there are two ways to purchase I Bonds. The first method uses Purchase Express which appears on your starting page when you log into your account. The trick with Purchase Express is that anything you buy will be in your name (the default registrant), as the sole owner. Purchase Express takes the money from your default payment source, whether a linked bank account or your Zero Percent C of I, your non-interest paying TreasuryDirect balance.

The other option is to choose Buy Direct from the main TreasuryDirect menu bar, and choose I Bond in the Savings Bond section. In addition to all of the other options, using Buy Direct makes you double-check where the money is coming from.

I once intended to purchase an I Bond with the balance from the proceeds of a matured security deposited to my Zero-Percent C of I. Unfortunately, I forgot that my linked bank account was the default funding source for Purchase Express, and the purchase sent my account into overdraft! Next you get the main screen for selecting the funding source and the amount of the bond purchase:

Below the selected option for Purchase Frequency which defaults to the next regular working day at the Treasury, you will see a number of options on TreasuryDirect for scheduling recurring or future purchases of bonds not shown here. In both cases, using Purchase Express or Buy Direct, it's almost too easy to purchase bonds, and in fact, the TreasuryDirect site will allow you to err.

If you try to purchase more than $10,000 in I Bonds in a single year for one social security number, the website will allow it, but you'll hear from the Treasury by e-mail afterwards. Either they'll give you a "Don't do it again" warning, or they'll reverse the purchase, and they reserve the right to freeze your account if you're a serial offender.

Checking Current Holdings

Choose the Current Holdings option from the TreasuryDirect menu bar, then select Series I Savings Bond at the bottom of the page and hit the Submit button. You'll get an accounting of all of your current I Bond holdings, as shown in the edited screen below:

Note that TreasuryDirect always reports the face value of holdings separately from the current value, with accrued interest. In many information screens, they only report the face value, and you have to generate a Summary or other detailed report to see the current value. The details screen for the single I Bond selected with the radio button on the left (only one can be selected at a time) then appears:

Changing Bond Registration (Ownership)

To change the registration of the bond, meaning how it is owned and who owns it, chose Edit, and you will be prompted to answer a previously established security question. Once you have done so, the following screen appears:

Note that the TreasuryDirect site changed the navigation path shown at the top of the screen from Current Holdings to Manage Direct. You could have reached this point by starting in Manage Direct, but I find the Current Holdings navigation to be easier. Your choices are to pick another individual from the Registration drop-down menu if you've already added people to the account in the past, or to Add New Registration, which means adding somebody's name and social security number, as shown below. The Modify Selection button allows you to choose a different I Bond without starting all over again.

In the example given, I am gifting the bond to my imaginary son, Harold, making him the Sole Owner. Be very careful about checking off the box for "Make this my preferred registration" since the implication is any new security you buy with Purchase Express on the initial TreasuryDirect page will now be registered in the new name. In the previous screen, I edited out the blank spaces for the Second-Named Registrant.

There are three options for ownership: Sole Owner, Primary Owner and Beneficiary. Sole Ownership is the default for the person who sets up the account and buys through Purchase Express. If you are the Sole Owner of a bond and you die, the bond becomes part of your estate. If you assign two owners to a bond, only the Primary Owner can make changes or redeem the bond, but the Primary Owner can authorize the Second Owner to do so. If either owner dies, the surviving owner becomes the Sole Owner. A Sole Owner can also add a Beneficiary to a bond, but the Beneficiary has no rights to the bond until the Sole Owner dies. For estate planning purposes, a bond with a surviving Second Owner or a Beneficiary does not become part of your estate when you die, rather ownership is transferred directly to the survivor.

Parents and guardians of minors (a child under 18) can register bonds in the child's name by setting up a TreasuryDirect account for that child which is linked to your own. Your access to that linked account will be through your main account.

Full Or Partial I Bond Redemption

We've already seen how to check our Current Holdings using the menu navigation, but I'll repeat a screen showing the details for an I Bond rather than sending you back several pages to search for it:

This time, rather than choosing Edit to change the registration for the bond, we choose Redeem. I recall this made me nervous the first time I tried it as I was afraid the Treasury would immediately cash the full bond and dump it into my account, but it just produces the Redemption Request screen below:

Under the Redemption Instructions at the bottom of the screen, you can choose whether to redeem the full amount of the bond, or just a partial amount, like making a withdrawal from a savings account. You also choose whether to have the money credited to your Zero-Interest C of I or to your linked bank account, which probably doesn't pay much more! TreasuryDirect generates 1099 INT at the end of the year in which you fully or partially redeem a bond, which will report the amount of interest that is subject to federal income tax.

Are I Bonds A Good Deal Today?

It's easy for professional investors to look at the zero percent fixed rate that I Bonds are currently paying and laugh, but how much interest are you earning on your bank account? As I write this, it's tough to find a bank that will pay even 1% on deposits, even in a money market account with over $100,000. CD rates are no better, with even the 5 year CDs under 2% when I just checked. Unless you believe that inflation will be under 2% for as long as you're interested in holding I Bonds, or you worry that you might need the money back in less than a year, I Bonds paying just the inflation rate look better than anything banks have to offer. Plus, if you live in a state with an income tax, I Bonds are exempt.

It's true if you cash your I Bonds in a year when you have a lot of income, you'll owe federal income tax on the accumulated interest, which will means you'll lose a little to inflation with current I Bonds that pay no fixed interest, but you'll lose even more on bank interest which isn't exempt from state taxes. For savers want nothing to do with the stock market gyrations and the tremendous principal risk that comes with investing in fixed rate bonds, I Bonds are a way to sleep a little better at night, even if you still grind your teeth.

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