If you’re a regular reader of this blog, you know that I stress the importance of having a sizeable emergency fund. You never know when life might hit you, so having cash on hand is extremely important.
Unfortunately, keeping an emergency fund often comes with a trade-off. Rather than invest your money, you’re forced to keep it in a bank account earning minimal interest. Over the long run, the value of your cash will erode due to inflation. It’s the price you have to pay for certainty.
Long ago, however, I figured out that there were ways I could have the best of all worlds, getting both the certainty of cash and high returns that would match or exceed inflation. To do that, I started using a system of mega-high-yield savings accounts. These are savings accounts that offer 3% to 6% interest in FDIC-insured savings accounts. The catch is that they come with limitations and require some upfront work to set up. But once you have everything set up, it all runs itself (for more info on this strategy, check out my post: Where To Get 5% Interest Savings Accounts).
Like most things in life, there have been some changes over the years. Some mega-high-yield savings accounts reduced their interest rates. Others have added requirements that make the accounts more difficult to use. Recently, one account I was using, HMBradley, nerfed its 3% interest savings account, leaving me with a bit of cash I needed to put somewhere.
That’s when I started looking at I Bonds. Earlier this week, I bought my first I Bonds, with the plan of incorporating them into my emergency fund strategy (and possibly as a sort of stable, long-term investment). I Bonds are an interesting option for someone looking to get a better return on their cash. And while there are some important limitations with them, I think they represent a good option for someone looking to bolster their emergency fund.
In this post, I’ll go over what I Bonds are, the important things to know about them, and how I’m planning to incorporate them into my emergency fund.
What Are I Bonds?
I Bonds are formally called Series I Savings Bonds. They are bonds issued by the US Department of the Treasury. Like any bond, when you buy an I Bond, you’re loaning money – in this case to the United States – with the promise that they’ll pay you back with interest. While technically an investment, because I Bonds are backed by the full faith and credit of the US government, they’re essentially guaranteed.
I Bonds are interesting because they offer a variable interest rate that’s based on the inflation rate. The specifics of how this rate is calculated isn’t important for our purposes, but essentially, an I Bond will always at least match the inflation rate. The rate is adjusted every six months, with new rates published on May 1st and November 1st.
When you buy an I Bond, you’re guaranteed the rate you bought it at for 6 months. After the 6 month period, the rate will adjust to whatever the last published rate was. So, for example, if you buy an I Bond in January, you’re guaranteed the rate that was published in November of the previous year. After six months, your I Bond rate will adjust to the new rate published in May. Interest is accrued monthly and compounded semiannually.
In many ways, an I Bond is a lot like a CD with a variable rate that adjusts every 6 months. And since I Bonds always at least match inflation, that makes them an attractive spot to store cash.
So, that’s a brief summary of what I Bonds are. I always recommend getting your information directly from the source, so be sure to check out Treasury Direct for more information about I Bonds.
Important Things To Know About I Bonds
Before you get started with incorporating I Bonds into your emergency fund strategy, it’s important to understand the limitations that come with them. Make sure you understand all of these key points before you get started.
1 Year Holding Period. Perhaps the most important thing to know about I Bonds is that they come with a 1 year holding period. That means when you purchase I Bonds, you cannot redeem them for one year from the date of purchase. After 1 year, you can redeem them at any time. The 1 year holding period is a big deal if you’re using I Bonds as a place to store your emergency fund. The short of it is, do not put money into an I Bond if you might need that money within 1 year.
5 Year Redemption Period. After one year, you can redeem your I Bonds at any time. However, if you redeem them before five years, you forfeit the last 3 months of interest. This is a fairly minor limitation, as in most circumstances, even with losing 3 months of interest, you’ll still earn at a far better rate than having your money sit in a savings account. After five years, you can redeem your I Bonds at any time without penalty. The maximum length you can hold an I Bond is 30 years. Any I Bonds that you hold for 30 years are automatically redeemed at that time.
Tax Treatment. I Bonds get a favorable tax treatment compared to other forms of savings because you don’t pay taxes on the interest you earn until you redeem the I Bond. This differs from a bank account, where you pay taxes on the interest every year, regardless of whether you take the money out or not. This tax-deferral means that you’re able to reinvest your interest without paying taxes on the earnings (interest is paid monthly and automatically reinvested every 6 months). This allows you to get more bang for your buck since you won’t have the yearly tax drag holding you back.
In addition to tax-deferred savings, I Bonds also benefit from being exempt from state and local income taxes. This makes I Bonds another favorable savings vehicle, especially if you live in a high tax state.
Purchase Limits. Because I Bonds have a favorable interest rate and some favorable tax treatment, the government limits how much you can purchase in a calendar year. You’re limited to $10,000 of I Bonds each calendar year. However, this limit is based on each individual. If you’re a two-person household, you can purchase up to $10,000 of I Bonds under your name and your spouse or partner can purchase up to $10,000 in their name. In addition, you can also purchase up to $10,000 in your children’s names. Finally, you can also purchase up to $10,000 for each business you have, including sole proprietorships.
On a practical level, that means this purchase limit is pretty high. In my own family, for example, I could purchase at least $50,000 of I Bonds each calendar year – $10k for me, $10k for my wife, $10k for my son, $10k for my business, and $10k for my wife’s business. I’m not in a position to put that much into I Bonds right now, but it’s nice to know the possibility is there.
Tax-Free If Used For Qualified Higher Education Expenses. While not a big deal, it’s worth mentioning that I Bonds can be redeemed tax-free if used for Qualified Higher Education Expenses. You’ll need to do your research on what qualifies and what terms you need to meet (more info can be found here). I can see this being potentially useful for some people, especially if you need a short-term place to store cash for higher-education expenses. For most people though, a 529 Plan will be the better way to save for college.
How To Buy I Bonds
Now that we’ve run through the important things to know about I Bonds, the next question you might have is how do you buy I Bonds. You can only purchase I Bonds from the US Treasury Department website at Treasury Direct.
First, you’ll need to create a Treasury Direct account. You can do this by going to the Treasury Direct website and clicking the button that says “Open An Account.”
Next, you’ll click “Treasury Direct” and open your account.
On the next page, you’ll see all of the different entities you can open your account for. By default, you’ll be opening an individual account and that’s what most people will be opening. As mentioned, you can open one for each person in your household. If you have a business entity you want to open an account for, you can also opt to do that.
Finally, the next page will bring you to the application itself, where you fill out all of the relevant details. From here, you’ll also input the bank account you want to use to fund your Treasury Direct account. The most important thing here is to make sure you pick a bank account you’ll use for a long time. While Treasury Direct does let you change the bank account, it’s a massive pain to do so. Make it easier for yourself by linking your primary checking account that you know you’ll use for a long time.
After you submit your information, your account should get processed and you’ll receive an email with your account number. Save this email because you need your account number to log into your Treasury Direct account. I recommend storing this information in Evernote or Google Drive or whatever organizational system you use.
To purchase your I Bonds, you’ll log into your account and click the “Buy Direct” button at the top of the page. From there, you’ll end up at a page that gives you different securities and bonds you can buy. The I Bonds are labeled as “Series I – An accrual-type security with a combination interest rate of a fixed and an inflation rate.” Select that option to purchase your I Bonds.
From there, you’ll enter how many I Bonds you want to purchase. Remember, you’re limited to $10,000 of I Bonds in a calendar year. The system won’t let you go over that amount, so you don’t have to worry about accidentally buying too many I Bonds.
One interesting thing to note is that you earn the full interest for the month even if you purchase your I Bonds at the end of the month. For example, I purchased my I Bonds at the end of December. But no matter when I purchased it in December, the issue date is listed as December 1st. If you’re someone that likes to really optimize everything, it can make sense to time your I Bond purchases so that they happen near the end of the month.
And that’s it! Once you make your purchase, you’ll be able to see your holdings in your account. The current value will show you how much your I Bonds are worth if you cash out right now. If your I Bond is less than 5 years old, the current value will show you the value of the I Bond minus the 3 months of forfeited interest for cashing out early. As for the interest rate, I’m guaranteed this interest rate for 6 months from my issue date. After 6 months, the rate will change again to the most recent announced rate set by the Treasury Department.
An Issue You Can Run Into When Buying I Bonds
Setting up your Treasury Direct account and buying I Bonds isn’t difficult, but you can sometimes run into an issue where Treasury Direct isn’t able to verify your information. This is what happened with my wife. We tried to open an account for her and received the following email:
What makes this very annoying is that you have to mail in this form and sign your form in front of a special notary or something at the bank. My understanding is that it’s not a normal notary, so you have to call your bank to get them to help you. This is a major hassle, especially if you have a busy schedule. It also says it takes 10-15 days to get your account approved after they receive this form, and given how the government works, I can only imagine it takes longer than that.
I’ll update this section once we complete this verification process for my wife. Our hope was that she could buy $10,000 of I Bonds this year, but unfortunately, that’s not going to happen now since her account wasn’t automatically approved.
My I Bond Strategy
I Bonds are an interesting place to store cash, albeit your cash might not be as liquid compared to regular bank accounts or the mega-high-yield savings accounts I use. When you buy your I Bonds, you can’t withdraw your money for 1 year, so you do need to be strategic about the money you’re using. Personally, between my wife and I, we have $17,000 in mega-high-yield savings accounts that earn 5% or more interest. These are all liquid funds that can be withdrawn at any time. We also have an additional $6,000 earning 3% interest that can also be withdrawn at any time. That gives us $23,000 of liquid cash, which is very likely to cover most emergencies we might encounter.
Again, if you want to learn how I use these mega-high-yield savings accounts, definitely check out my post: Where To Get 5% Interest Savings Accounts.
Because I have plenty of liquid cash earning great rates, I’m comfortable with tying up some more cash in I Bonds. If you purchase the maximum each year, you’ll create an I Bond ladder. Some of your I Bonds will be within the 1-year holding period and can’t be withdrawn. But with time, most of your I Bonds will be outside of that period. Depending on how long you’ve been investing in I Bonds, some will be outside of the 5-year redemption period and can be withdrawn without losing any interest.
Even if you don’t want to regularly contribute to I Bonds, it’s worth maxing out 1 year of contributions now for the unprecedented high-interest rate. If you act quickly, you can max out two years of I Bond purchases. I just purchased $10,000 of I Bonds for 2021. In 2022, I’ll purchase another $10,000 of I Bonds, giving me $20,000 earning 7.12% for at least 6 months. After one year, I’ll reassess how I want to use these I Bonds in my overall savings strategy.
I’ve never thought of government savings bonds as a good savings vehicle. To me, it seemed like something that didn’t give much return, so why bother with it. But when the Treasury Department increased the interest rate on I Bonds this year, people started noticing. It’s only because other people noticed these I Bonds that I bothered to look into them. The fact that HMBradley nerfed their savings account gave me more reason to check out I Bonds.
Your emergency fund doesn’t have to be an either-or proposition. You can get good returns on your emergency cash with no risk of loss.
Right now, if you’re a two-person household utilizing all of the mega-high-yield savings accounts available, you should have $23,000 earning 3% to 6% interest in FDIC-insured savings accounts. If you utilize I Bonds, you can have another $20,000 or more earning 7.12% interest for 6 months. Even when the interest rates change, they’ll still earn at least the rate of inflation, which is more than any bank account can give you. And that’s all with essentially no risk of loss.