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.
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
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