Series I Bonds: What they are and how they work
Series I Savings Bonds (I Bonds) are U.S. Treasury savings bonds designed to protect investors from inflation while preserving principal. They are non-marketable (cannot be traded on a secondary market), backed by the full faith and credit of the U.S. government, and intended as a low-risk, inflation-protected savings vehicle.
Key features
* Interest combines a fixed rate (set for the life of the bond) plus a variable inflation rate (adjusted twice a year based on changes in the Consumer Price Index for All Urban Consumers, CPI‑U).
* Interest is compounded semiannually and added to the bond’s value (I Bonds function like zero-coupon bonds for tax purposes).
* Must be held at least one year; redeeming within five years forfeits the most recent three months of interest.
* Final maturity is 30 years (20-year initial maturity plus a 10-year extension).
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How interest is calculated
Each I Bond’s published interest is the composite rate, which combines the fixed rate and the inflation component. The composite rate is calculated as:
Composite rate = fixed rate + (2 × semiannual inflation rate) + (fixed rate × semiannual inflation rate)
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Notes:
* The fixed rate is set by the Treasury and remains the same for the life of each bond.
* The inflation component is recalculated every six months (applied from the bond’s issue date).
* The Treasury applies a floor of 0%: if the formula produces a negative composite rate, the composite rate is set to 0%.
Example (hypothetical)
* If the composite annualized rate is 5.27% and you invest $10,000, with semiannual compounding your first‑year interest would be about $535. Actual returns will vary as the inflation component can change every six months.
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Purchase rules and where to buy
- Primary purchase channel: TreasuryDirect.gov (electronic bonds).
- You can also buy paper I Bonds using your federal tax refund.
- Annual purchase limits:
- $10,000 in electronic I Bonds per Social Security Number.
- Up to $5,000 in paper I Bonds purchased with a federal tax refund.
- Minimum purchase amount for electronic I Bonds is $25; paper purchases have different minimums.
If you buy bonds with a tax refund, use IRS Form 8888 to designate the purchase.
Taxes and education exclusion
- Interest is subject to federal income tax but exempt from state and local income taxes.
- Interest is not paid out annually; it accrues and is taxed either:
- At redemption (cash method), or
- Annually on the imputed interest (accrual method), if you elect that method.
- Federal tax benefit for education: If redeemed and used for qualified higher education expenses in the same calendar year, interest may be excluded from federal income tax (subject to eligibility rules and income limits).
Pros and cons
Pros
* Very low credit risk — backed by the U.S. government.
* Automatic inflation protection via the variable component.
* Exempt from state and local taxes; possible federal tax exclusion for qualified education expenses.
* Predictable tax treatment and simple purchase process through TreasuryDirect.
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Cons
* Limited annual purchase amounts.
* Must be held at least one year; early redemption within five years incurs a three‑month interest penalty.
* Returns may be lower than many riskier investments over long periods (stocks, real estate).
* Composite rate can fluctuate, making long‑term forecasting uncertain.
* Not tradable in secondary markets.
Comparison with Series EE Bonds
- Interest structure:
- I Bonds = fixed rate + inflation-adjusted rate (variable).
- EE Bonds (post‑2005) = fixed rate for the life of the bond; certain EE Bonds issued have a guarantee to double in value if held 20 years (effectively a minimum long-term yield).
- Purchase limits for electronic EE and I Bonds are the same ($10,000 per SSN per year). Paper I Bonds may be bought via tax refund; paper EE Bonds have different historical rules.
- Use case:
- I Bonds are preferred when inflation protection is the priority.
- EE Bonds may appeal to savers seeking a predictable, long-term guaranteed return (when the doubling guarantee applies).
Practical considerations
- Use I Bonds as a safe, inflation‑protected portion of a diversified portfolio — suitable for emergency reserves, medium‑term savings, or education funding.
- Evaluate liquidity needs: the one‑year minimum hold and five‑year penalty may make I Bonds unsuitable for funds you might need in the short term.
- Monitor the inflation component (updated May 1 and November 1 each year) to understand how your bond’s composite rate may change.
Bottom line
Series I Bonds are a low‑risk way to preserve purchasing power during inflationary periods while benefiting from federal tax advantages. They are not a replacement for higher‑growth investments like stocks but can play a useful role in a conservative allocation or as a hedge against inflation. Consider purchase limits, holding requirements, and your tax or education‑funding plans before investing.