Some investments help you in multiple ways. Government-issued Series I Savings Bonds (I Bonds) help you in one way: they can be an excellent alternative for some of the savings you keep in bank accounts for long periods of time. For instance, your emergency fund.
Emergency funds are amounts held for unusual or unanticipated expenses. Many people have emergency fund equal to 3-8 months of expenses. Others have emergency funds much greater than that. Emergency funds are typically held in bank accounts.
Emergency funds could be used instead of selling investments for any sudden or unusual needs for cash. Maybe one spouse is laid off or a relative suddenly needs financial support. Or more positive needs such as paying for a child’s wedding or an unusually expensive vacation.
Advantages and Disadvantages of Bank Accounts
Emergency funds held in bank accounts are protected by a U.S. Government guarantee (up to a limit through the FDIC), don’t fluctuate in value and are readily available in a short period of time.
Disadvantages of bank accounts include the low interest rates paid on deposits and the need to pay taxes annually on the interest. The low rates of return and taxes cause bank accounts to lose purchasing power over time.
Advantages and Disadvantages of I Bonds
Series I Savings Bonds are an excellent alternative for part of an emergency fund. A more detailed discussion of how I Bonds work is available here. Or, go to the Treasury Direct website.
Advantages of Series I Bonds include:
- They usually offer a higher interest rate than most bank accounts.
- Indexed for inflation.
- Interest is exempt from state and local taxes
- Federal taxes on interest are not due until the bonds are sold, which could be as long as 30 years in the future.
- Guaranteed by the Federal Government in any amount.
- Completely liquid twelve months after purchase.
Disadvantages of I Bonds include
- Must be purchased through a Treasury Direct account, an initially more complicated process than depositing funds into a bank account.
- Once funds are used to purchase an I Bond, the funds are unavailable for 12 months. After 12 months, that bond may be redeemed at any time.
- There is a $10,000 per person per year limit on I Bond purchases.
- I Bonds cannot be purchased in an IRA (nor would you want to because of the tax advantages mentioned above).
- If you redeem a bond within five years of purchasing it, you lose three months of interest.
In my opinion, the advantages of I Bonds far outweigh the disadvantages.
Where Do Series I Bonds Fit in Your Portfolio?
I Bonds are not a good alternative to investments in stocks and funds that own stocks. Nor should they be used as an alternative to investments in intermediate and long-term bonds.
But I Bonds are an excellent alternative to funds held in bank accounts for long periods of time. The interest rates are typically higher than most bank savings accounts due to the inflation adjustment, they are government guaranteed, don’t fluctuate in value, the tax benefits make the return higher than compared to a bank account and the ability to postpone Federal tax (there is no state tax) until funds are withdrawn means no taxes may be due for up to 30 years.
Here is an example of an appropriate use for I Bonds. Spouses Jack and Jill keep $150,000 in bank accounts as an emergency fund. They know the bank accounts lose purchasing power after taking into account taxes and inflation. To help protect against loss of purchasing power, they decide to invest $20,000 per year ($10,000 for each spouse) of those funds into I Bonds. The combined amounts in I Bonds and bank accounts will be their emergency funds. Their goal is to have $60,000 in I Bonds and the remaining $90,000 in bank accounts.
Each time they invest $20,000 in I Bonds, that amount is unavailable for 12 months. So, the total amount immediately available would be $130,000 instead of $150,000 until twelve months after they make their last I Bond purchase.
Jack and Jill review their finances, expenses and income and decide that they can easily cover the $20,000 reduction in their emergency funds through some combination of investment withdrawals, their Home Equity Line of Credit or even credit cards if necessary. Since the I Bonds pay a higher interest rate than their bank accounts (and an even higher after-tax rate) and Federal taxes are postponed, they begin purchasing.