A new year brings a new quota for I Bonds. In the past few years buying the full quota was part of my ritual in January. That’s $10,000 for me, $10,000 for my wife, and another $5,000 from tax refunds later in April. You can also buy more for trusts if you have them.
The reason for the enthusiasm was that I Bonds at 0% fixed rate plus inflation were a much better deal than TIPS at negative real yields. Yields on 5-year TIPS were as low as -1.5%. Now that PenFed Credit Union extended the 3% rate on 5-year CDs to January, I’m not so sure whether I should still buy I Bonds as usual or just buy more 3% CDs from PenFed.
I Bonds bought now pay 1.38% composite rate for the first six months, and then 0.2% plus inflation afterwards.
Compared with CDs, I Bonds still have some small advantages:
- tax deferral
- no state income tax
- low early withdrawal penalty
- tax free if used on higher education, subject to income limit
These advantages are very small to me. Tax deferral doesn’t add much when the composite rate is below 2%. The same for no state income tax. You are not paying much tax when you are not earning much interest to begin with.
If I need cash I can draw from other sources. The tax free treatment when used on higher education can be more easily obtained by contributing to a 529 plan. No income limit there.
The large factor is of course the rate. For I Bonds, that’s driven by future inflation. What will inflation be in the next five years? No one knows. We can look at estimates though.
TIPS-Treasury Breakeven Rate
According to US Treasury, 5-year nominal Treasury yield is 1.73%. 5-year TIPS yield is 0.04%. The 1.7% difference is more or less the market’s expectation for inflation in the next five years, plus or minus small factors for inflation risk premium and nominal Treasury liquidity premium.
Cleveland Fed Estimate
Federal Reserve Bank of Cleveland publishes estimates for inflation expectations every month. It uses
a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the “break-even” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates.
The web page only shows the 10-year estimate. The linked spreadsheet at the bottom of the page shows the 5-year estimate (column F). That number is 1.6% in the latest estimates.
I Bonds Composite Rate
I’m not going to quibble whether the inflation expectation should be 1.6% or 1.7%. Add 0.2% fixed rate, I will call it 2%. That would be the best estimate for the average annual composite rate on I Bonds in the next five years at this moment. After all, what do I know about inflation that the market doesn’t know?
If I buy I Bonds now, versus PenFed CDs, I would expect to give up 1% a year for inflation protection. Inflation protection is important, but it’s not worth 1% a year in the current environment.
I decided to break my ritual and not buy I Bonds this month. Actually I’m going to redeem my 0% fixed rate I Bonds bought in previous years and put them in PenFed CDs.
Note I’m treating I Bonds and PenFed CDs as long-term holdings. If you just want to park some money for a year or two or have a cash reserve, I Bonds are still good.
[Photo: paper I Bond from my own collection.]
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Michael says
Good analysis. We’ll likely re-up with I-Bonds this year as they help protect us against unexpected inflation. Also, with four pre-college kids, we’ll have plenty of opportunities to pocket the interest without paying taxes. That narrows the gap vs. CDs substantially.
Steve says
What about the use of i-bonds as a “real dollars” emergency fund?
Harry says
I Bonds become liquid cash after one year. They are good for an emergency fund.
Patricia says
Harry, if I can contribute $5500 to a non-deductible traditional IRA (no option for a Roth back door b/c not willing to pay taxes and have no 401-k to roll into), would it be a good idea to make use of the allotment to buy a Penfed 5-year CD? I usually do not make a t-IRA contribution because we have enough tax-advantaged space between my spouse’s 401-k (pre-tax and post-tax) and spouse’s backdoor Roth. Plus, we have been maxing out I bonds. This year, we cannot both max out I Bonds and make a t-IRA contribution. Would you recommend putting part of the $20K we would have put into I Bonds into the t-IRA? We are not interested in a taxable CD. Our tax rate is high right now, but we expect it to be about 15% in retirement. Thanks for your great blog.
Harry says
I wouldn’t bother for only $5,500 unless you expect to have the backdoor Roth option open up to you in a few years.
Steve says
A non-deductible T-IRA is generally not worth using as far as I understand (except for things like a backdoor Roth). At least with today’s tax structure, where ordinary income rates are higher than investment income rates.
Tipswatcher says
I made the same decision. I usually buy I Bonds up to the limit in January, but I will wait now and my first investment of the year was the PenFed CD. I have a couple of TIPS maturing in January and April, so I will need to reinvest that money. But I will be buying I Bonds to the limit (I don’t do the tax return ploy). Because you can only buy $10,000 a year per person, it is impossible to build a sizable stockpile of I Bonds unless you buy them every year. I am still in my accumulation years, so I will be buying.
I love I Bonds as a super safe chuck of my fixed-income allocation. But I always caution that I Bonds and TIPS are investments for people who are preserving capital, not building it.
Bill says
Another advantage of the PenFed CDs, at least if they are in an IRA account, is that PenFed allows you to withdraw from the CD down to a minimum of $1000 without any penalty. So, if in the next 5 years a better rate or better investment appears, you just withdraw down your PenFed CD to the $1000 minimum and transfer it to the new investment. It sounds crazy, but I double-checked it with them. Makes it a no-brainer.
Also, for what it is worth, CDs at PenFed are insured like bank deposits.
Marc says
Bill, I think your post requires some clarification.
First, PenFed allows partial withdrawals only if the account holder is 59 1/2 or older.
Secondly, – and this is critical – PenFed will designate the partial withdrawal as a distribution, that is, as a taxable event. The tax deferral of the amount withdrawn ends at that point.
Harry says
@Marc – I don’t think your second point is true. Partial withdrawal from the IRA CD goes to the IRA share account. It’s still within an IRA.
Marc says
No, the partial early withdrawal is treated as a distribution and goes to a non-IRA share account.
If that were not the case, PenFed would, in effect, be allowing holders of CD’s within an IRA to bypass the terms of the original CD without penalty, retain the tax deferral, and take advantage of higher rates – either at PenFed or elsewhere.
Harry says
That’s exactly what they are doing — allowing IRA holders over 59-1/2 to take advantage of higher rates penalty-free. Here’s a report by a PenFed customer:
“For my mother, who already had a PenFed 5-year and 7-year CD at 2% & 2.25%, respectively, we withdrew all but $1k + accrued interest (for that month) out of each CD into her IRA Share Account and opened a new 5-year 3.04% CD. There was $0 in penalties taken out.”
http://www.bogleheads.org/forum/viewtopic.php?p=1905613#p1905613
It was from actual experience, not just what customer service reps said. Customer service reps often don’t have the accurate information.
Marc says
Harry, yes, my assertion was incorrect.
After finally getting through to PenFed this evening and pressing the question with the representative (who double-checked with one of their IRA specialists), I learned that PenFed will indeed allow early (partial) transfers of IRA balances to either new IRA CD’s at PenFed or at other institutions – all without penalty if the account holder is over the age of 59-1/2.
Sorry for the misinformation.
Harry says
No worries, Marc, not your fault. PenFed should train their customer service reps better. Different reps were giving different answers to different customers. That’s causing a lot of confusion.
pop says
Good comparison. Sometimes difficult to take your mind out of the box :-). My problem is that I wonder where this will fit in asset allocation. I have divided my fixed income portion equally into regular fixed income (VBTIX) and Inflation adjusted Fixed Income (TIPS,TIPS Funds and I Bonds). I am currently under allocated on the inflation adjusted side. Also my fixed income fund is in my 401(k) which I do not want to disturb. I wonder whether for next five years by putting the Pen Fed CD under my inflation adjusted fixed income (you could call that cheating :-)). As the early withdrawal penalty is interest for an year and does not eat into a principal, I can always withdraw if either the inflation or interest rates shoot up abnormally.
Does this line of reasoning sound logical?
Pam says
Excellent post, Harry. I didn’t see one question addressed though. IBonds can only be purchased for a limited sum per year per SSN. If you sell some I-Bonds to purchase CDs, and then inflation rate shoots up down the road (say 10-20 years from now), you have lost that purchase slot. You can purchase I Bonds again, but you cannot buy back the ones you sold from previous years. So this issue seems more complicated than just looking at 5 years worth of expected I-bond return…
What are your thoughts on higher future inflation?
Harry says
Pam – There’s no limit in buying TIPS. When these CDs mature, you can always buy TIPS if desired.
The 0% and 0.2% fixed rate I Bonds won’t be worth holding onto when yields on TIPS are much higher. The yield on 10-year TIPS is already 0.6% today. If you hold the 0% I Bonds for 10 years, you already give up 0.6% every year for 10 years. Suppose you like the attribute of I Bonds and you accept that 0.6%/year as the cost for having a value that never goes down. Would you still accept that cost when the yield on 10-year TIPS is 1.2%? At some point it will make sense to sell the 0% and 0.2% fixed rate I Bonds and buy TIPS instead. At that time, you will lose the slot voluntarily anyway.
Pam says
Thanks Harry. That makes sense.
Wouldn’t the price of TIPS factor in the high inflation at that point? In other words, would not it be more expensive to purchase TIPS at the point the inflation is trending upwards?
Of course, it makes sense to purchase TIPS for inflation protection once CDs mature, assuming the yields are not negative.
Harry says
Pam – I was referring to the real (after-inflation) yield on TIPS, which doesn’t necessarily go the opposite direction of inflation. Witness the real yield on TIPS went negative in the last few years when both realized and expected inflation was very low. TIPS didn’t get less expensive when inflation was trending downward. Now the real yield is up when inflation is still low. If inflation goes up, the real yield on TIPS may go up or it may go down; you just never know. You hang on to the 0% and 0.2% fixed rate I Bonds if you think you are unlikely to beat those yields in TIPS. I’m more optimistic.
IRMMA Must Go says
I purchased my first I-Bonds in late October 2021. I guess I was expecting interest to post monthly to the treasurydirect.gov portal, but as of Dec 2, I still do not see any interest. When does I-bond interest get posted to the portal?
Harry Sit says
Starting in the fourth month. Interest earned in the first three months is held back as a potential early withdrawal penalty if you cash out within five years. It’ll be released after five years.
IRMAA Must Go says
Much appreciated. As a follow-up, since I purchased the i-bonds around the 27th of the month, will my first month’s interest be fractional (like 4/31 of a full month’s interest amount), or do they wait to begin accruing interest until the first full month of ownership? In other words, how is interest calculated and posted if you don’t buy at the month’s end/start?
Harry Sit says
You earn the full month’s worth of interest in the month of purchase as if you bought on the first of the month.
IRMAA Must Go says
Awesome. Thanks so much.
IRMAA Must Go says
One more question: if you use your tax return to purchase i-bonds, is that purchase considered made in the current (after Jan 1) tax year, or the previous year (tax year for which you are receiving the refund)? What I’m getting at is it possible to use 2021’s $5K i-bond purchase limit from the tax refund I might receive in late winter/early spring CY2022 to effectively “catch-up” on I-bond purchases, or have I missed the TY2021 window for using the $5K limit?
Harry Sit says
Current tax year, when the bonds are actually issued.