We like Series I savings bonds for the combination of inflation protection and tax advantages – and the accompanying boost in terms of tax equivalent yield. They're not sexy, and they're not exciting, but they are a valuable part of our portfolio.

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I Bonds in a Portfolio

The tax advantages and low risk of I Bonds means that almost any investor has room for them in his or her portfolio.

I bonds, like any other investment, have certain qualities that may make them more or less attractive to you as an investor. By comparing what risks are associated with I bonds, researching their advantages, and comparing them to other assets, you can determine if I bonds belong in your portfolio, and in what type of account.

Rates

Although each individual has unique needs and goals, I Bonds almost certainly have a place in an investor's portfolio. A new I Bond has seen rates anywhere from 2.19 % to 7.49% with an average of 4.88% as of November 2005. Bonds purchased when the fixed rate was 3.4% or higher have seen rates over 9% for several intervals since originally bought. Depending on the rate of the bond, the rate can range from slightly better than Certificates of Deposit or high rate Money Market accounts to nearly the same as the average of the stock market over the past 80 years. Combined with the excellent tax protection benefits and very low risk expectations of I Bonds, all investors should consider owning at least some I Bonds.

Asset Allocation is the single most important element in creating a portfolio for your needs. While most professionals agree bonds should make up part of your portfolio, the exact amount depends on many factors. A general good rule of thumb is to hold your age as a percentage in bonds in your overall portfolio. For example, a 25 year old would hold 25% bonds and 75% stocks and other investments while a 50 year old would have 50% bonds and 50% other products. Determining what portion of that percentage of bonds you own is devoted to I Bonds is a personal choice dependant on many factors. While most bonds move opposite to the movement of stocks, I Bonds correlate to the movement of inflation, meaning both traditional bonds and I Bonds can be held together to create a diversified bond portion of your overall portfolio.

I Bonds for Educational Expenses

In addition to the tax advantages of I bonds for all investors, there are additional tax advantages for bond owners who redeem the bond to pay for educational expenses. When a bond owner pays qualified higher education expenses at an eligible institution, part or all of an I bond's interest is excluded from the owner's gross income at tax time.

While the tax break for educational expenses is great, it is important to follow the requirements for qualification, which are somewhat unintuitive. First, the student attending college can not be listed as the owner or co-owner of the I bond. If they are listed on the bond, it should only be as a beneficiary. The owner of the bond must be over the age of 24 on the first day of the month that the bond is purchased. The educational expenses must be at an institution that qualifies for federal assistance and take place in the same tax year that the bond is redeemed. If you are saving for your child's education, ensure you are the owner, the child is not listed as an owner, and that you are at least 24 when purchasing the bonds. The bonds can be used for qualifying expenses, such as the cost of a course or tuition, but can not be used to cover the cost of room and board or textbooks for the class.

When used as a savings mechanism for college costs, I bonds have many similarities to 529 accounts, which are special tax-advantaged accounts designed for saving for college. Both I bonds and a 529 account will allow you to save tax-free and potentially pay for higher education costs without being taxed on the profits. A 529 account lets the owner choose the investment classes in the account, which could potentially perform much better or worse than an I bond, which can never lose value. Since a 529 account is designed for educational purposes, if your child does not attend college, you are forced to either change the intended recipient of the account or face larger taxes on redemption. With I bonds, there is no requirement that they be used for educational expenses, so they could be redeemed without an additional penalty on top of the normal taxes required. I bonds have a relatively low annual purchase limit of $5,000 for electronic and paper bonds, meaning a 529 may help you save more in a tax-advantaged way in the same time. Regardless, the higher education tax breaks on I bonds provide an extra advantage for investors who may some day decide to redeem the bonds for educational costs in the future while offering the flexibility of redeeming the bonds for other reasons instead.

Additional information on the qualified expenses, income limitations, and other restrictions is available on the TreasuryDirect site: Education Planning (http://treasurydirect.gov/indiv/planning/plan_education.htm).

Details on the tax advantages of I bonds can be found in the IRS Publication 970, Tax Benefits for Education (http://www.irs.gov/publications/p970/index.html).

I Bonds and Taxes

I bonds are tax deferred products by nature. This means that taxes are only incurred when the bond is redeemed, unlike CDs or stocks bought in a taxable account, which are taxed every year. For most investors, that means I bonds will grow faster than similar investments that do not have inherent tax advantages. Individuals in a high tax bracket may want to reconsider redeeming bonds as the tax applies to both the interest component and fixed component of the I bond's rate. If redeemed in a period of high inflation and in a high tax bracket, some investors may realize a negative return on investment when adjusted for inflation. But, because I bonds continue earning for 30 years, most investors can hold onto the bonds until they are in a lower tax bracket, and then redeem the bonds. The lower the tax bracket you are in when you redeem the bond, the higher the real return you will achieve.

Because I Bonds are tax deferred, they can safely be placed in the taxable portion of your portfolio. Unlike bond funds or company bonds that are tax inefficient, I bonds have little tax considerations and therefore can be excluded from space in your retirement accounts such as a 401k or IRA. By having I bonds outside retirement accounts, this allows for more room in those accounts for other, less efficient assets like equities or other bond types.




Page last modified 1/16/2012