I mentioned in an email update I’m planning to sell all my Series I Savings Bonds (“I Bonds”) with a fixed rate of 0.3% or below next year. These I Bonds were bought during the last 9 years. The fixed rate on I Bonds was between 0.0% and 0.3% since May 2009, until it was raised to 0.5% only this month.
My motivation to sell is primarily driven by the large gap between the low fixed rates on those I Bonds and the current TIPS yield. For example the current real (after-inflation) yield on 5-year TIPS is 1.1%. The yield on longer term TIPS is even higher.
Several readers replied and pointed out some reasons for keeping the I Bonds despite their low fixed rates:
1. The existing I Bonds already accrued some interest. Selling them now will trigger paying federal income tax on the accrued interest (I Bonds are exempt from state and local taxes).
2. If some of the I Bonds haven’t been held for 5 years, selling them now will forfeit 3 months worth of interest.
3. I Bonds are tax deferred. If your tax rate is high now and it will be lower when you retire, holding on to them until you retire will arbitrage the difference in tax rates.
4. I Bonds are guaranteed never to lose value.
5. There is a limit on how much new I Bonds each person can buy each year. If you max out your quota for I Bonds at the new 0.5% fixed rate, you won’t be able to buy additional I Bonds after selling your existing I Bonds. The money has to go somewhere else (regular bonds not indexed for inflation or TIPS), none of which has features #3 and #4.
These factors in favor of holding on to the low-rate I Bonds are all true. Still, there has to be point when it’s better to sell and switch to TIPS. If 1.1% real yield doesn’t do it, what about 2.1% or 3.1%? Will you still hold on to 0.3% fixed rate I Bonds when you can get TIPS yielding 3% after inflation? There is no limit on how much TIPS you can buy.
We need to quantify the advantages of holding on to the low-rate I Bonds. Then we will see whether the advantages are able to overcome the yield difference. I created a spreadsheet for comparing two scenarios:
A) Hold on to an existing I Bond. Defer tax to the future when the tax rate is potentially lower.
B) Pay any tax and penalty now. Invest the proceeds in TIPS in a taxable account. Pay tax on interest every year.
The spreadsheet is interactive. Assumptions are in blue. Please feel free to change those to numbers applicable to you. The other cells are calculated. Please don’t overwrite those.
You get the current value and the composite interest rate of your I Bond from the Savings Bond Calculator. If the bond hasn’t been held for 5 years, the value displayed by the Savings Bond Calculator already reflects the 3-month interest penalty. If you don’t remember the fixed rate for your I Bond, you can look it up by its issue date.
In the scenario shown, I have an I Bond bought in 2010. The fixed rate is 0.2%. It’s been held for more than 5 years already. In Scenario A I would hold it for another 22 years. The average inflation in the next 22 years is estimated from the difference in yield between 20-year nominal Treasury bonds and 20-year TIPS. Finally, suppose I pay a higher tax rate in the next 22 years than the tax rate afterwards.
Under those assumptions I’m still better off with switching to TIPS and just pay taxes every year, even at a higher rate. If my tax rates are more or less equal between now and the future, it will be even better to switch to higher yielding TIPS because there isn’t much tax rate arbitrage. If I’m able to put TIPS in an IRA it will be better still.
The result may be different under a different set of assumptions. So play with the spreadsheet with your own assumptions and different scenarios and see how it goes for you.
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Peter H. says
As you point out, historically I-Bond fixed rates have been lower than TIPS yields. I believe the reasons for the lower yields reflect:
1. The tax differences you mention (plus the potential for certain taxpayers to avoid taxes entirely if I-Bonds are used for educational expenses)
2. The redemption feature (guaranteed liquidity at any point before maturity). You have to be confident to hold TIPS to maturity or accept market risk. For example, if you are trying to build a TIPS ladder, I-Bonds can effectively fill in the missing maturities.
3. Automatic reinvestment of all interest at the same real rate (full inflation protection of all interest). There is no guarantee that today’s TIPS yield will be available when it comes to reinvestment of interest (although that is the assumption in the TIPS yield calculation)
4. A much more valuable deflation option on I-Bonds — I think many people don’t appreciate this fully. You never give back past inflation returns on I-Bonds, whereas you do with TIPS and only the final principal payment is guaranteed. One result is that I-Bond returns are enhanced by deflationary periods, and even some 0% fixed rate I-Bonds have had (modestly) positive real returns if they experienced deflationary periods (last I checked there have been 2 such half-year periods since I-Bonds were first issued.)
In my view, the reason for buying TIPS or I-Bonds is to protect against unexpected inflation. A pure yield comparison based on expected (market-implied) inflation is an incomplete comparison.
Harry Sit says
All true. The question still stands: should you keep the 0% I Bonds no matter what? The benefits have to be quantified. Please feel free to supplement the analysis to take into account the additional consideration you brought up. The inflation number is an input value. You can change it to something else for additional what-if analysis.
Peter H. says
Unfortunately, there are many moving pieces, making an apples to apples quantitative comparison very difficult. Some thoughts:
1) if you are not otherwise at the annual I-Bond limit your spreadsheet can easily be used to see if it makes sense to sell the 0% and buy the 0.5% I-Bond.
2) the historical average discount of the I-Bond fixed rate to the immediately prior month-end 30-year real TIPS yield since 2010 is 0.97%. If the government has a rational process for setting the I-Bond rate perhaps that’s an estimate of the average value of the I-Bond benefits. The current discount is less than that average, suggesting I-Bonds are a relatively good deal.
3) as I said in my initial reply, I see both I-Bonds and TIPS as insurance against unexpected inflation. I-Bond insurance is more comprehensive. I don’t mind paying the higher premium because my focus is on locking in spending power, not making an extra few basis points. This is partially because my timeframe is 20-30 years, which is where inflation risk is the greatest. It arguably matters less with your indicated 5-year timeframe.
Harry Sit says
Nothing stops the government from setting the I Bonds fixed rate arbitrarily low. Maybe they have been overpricing I Bonds (i.e. setting the rate too low) all along. So I’m not sure the historical average 0.97% difference is a good indicator for the benefits. The benefits also vary by the tax rates, holding period, available space in tax deferred accounts, and so on. I also don’t mind paying a higher premium (receiving a lower rate) over TIPS. How much higher/lower is the question. Yes it’s difficult, but we still need to think about it. Otherwise we end up accepting I Bonds blindly at any price.
Peter H. says
We agree it’s complicated. The 0.97% average is surely imperfect, but it’s a data point. As is the projection of tax-effected yield in your spreadsheet. I was trying to present some other “thinking about it.”
A couple of years ago I compared the after-tax hypothetical return of an I-Bond with a 0.1% fixed rate and a TIPS with a 1% coupon over two thirty-year inflation periods: 1915-1945 and 1985-2015. I-Bonds beat TIPS in the first period, which was volatile and had significant periods of deflation. TIPS won in the second period, which had generally low and stable inflation. Another data point.
TJ says
Are you buying individual TIPS? If you’re buying a mutual fund of TIPS, aren’t you risking NAV loss?
Harry Sit says
Individual TIPS or TIPS fund or ETF is a secondary issue. At some price level the NAV loss is worth risking. Receiving below-market income is also a loss.
gmshedd says
Wouldn’t 5-year 4% CD’s (with 6 month penalties so you can buy your way out if inflation and yields go up rapidly) provide a higher yield and inflation protection, without as much principal risk prior to the 5 year maturity date.
Harry Sit says
A 5-year 4% CD with small early withdrawal penalty still doesn’t provide inflation protection. When you get out after inflation goes up rapidly, it’s possible the prevailing nominal yield does not catch up to inflation and the prevailing real yield turns negative as it did several years ago.
FinancialDave says
Harry,
I am not seeing how your future taxes figure into a decision in this comparison.
You try to compare the yearly payment of interest on TIPS to the accrued interest of the I-bonds, but you know you can pay interest on the I-bonds annually if you so desire, so that consideration does not seem to enter into the equation.
IMHO the biggest factor favoring I-bonds is that they can never lose money and right now if you buy an I-bond today it will pay you .5% ABOVE the inflation rate for however long you hold it — will your TIPS do that – no they won’t. In fact in a rising interest rate environment they are potentially going to be bad news, especially if rates rise to fast.
For instance let’s look at what would have happened if you had bought TIPS a little over 5 years ago on Dec 31st 2012 and held them to Dec 31st 2017. By my calculation you would have lost $24 for each $10,000 you bought of the Vanguard Intermediate TIPS fund. Some other funds may be different, but I think you can see that after 5 years your investment would still be underwater. That is why I don’t invest in TIPS, after seeing them lose almost 9% in 2013.
Harry Sit says
Having to pay tax every year when you hold TIPS in a taxable account is a disadvantage. Considering tax rates gives credit to I Bonds. Paying tax on I Bond interest throws away one of its advantages.
If you don’t want to sell I Bonds no matter how high TIPS yield is, its “never lose money” benefit becomes more theoretical. The yield on 5-year TIPS in December 2012 was negative 1.35% while the fixed rate on I Bonds bought at that time was zero. No wonder I Bonds did better.
Bruce Wilson says
I now understand how I-Bonds work a little better, thanks Harry.
I have now inventoried my I-Bonds and know which ones have the 0% fixed rate.
I don’t like the way Treasury Direct deals with tax notification on the single TIPS bond I own, – an Email of the 1099, you have to print. I fear they wouldn’t be to sympathetic if the interest was forgotten even if their Email didn’t go thru. I don’t plan to buy anymore TIPS simply for that reason.
I think I will keep my I-Bonds, but keep the 0% fixed rate bonds on my radar if i need cash.
I learned some today.
Thanks Harry and the other posters.
Harry Sit says
You can buy individual TIPS or a TIPS fund or ETF in a brokerage account as well. The broker does a better job in sending the 1099 forms.
FinancialDave says
Bruce,
Good point about keeping an eye on those 0% fixed rate I-bonds. Seems like a good long term plan to sell the 0% to buy a higher fixed rate with the proceeds. Other than the small tax involved, which would be paid eventually, if you have held them more than 5 years I can’t see a disadvantage to trading up, especially if you are in the 12% tax bracket like I am.
Carrie says
Hi Harry,
I was wondering why you would hold TIPs in an after tax account versus pre/roth accounts. If one liquidates I-bonds , the equivalent amount of $$s could be held in tax-advantaged account in TIPs while purchasing equivalent $$s of more tax-friendly stock index funds in after-tax account (just swapping the location). You’ve mentioned this strategy previously.
Tyler says
I won’t speak for Harry, but I assume he’s trying to defeat the obvious “no more room in tax advantaged accounts to buy TIPS with” argument. His point is that at some point even the unthinkable (buying TIPS in a taxable account) may make sense if the yield spread between I Bonds and TIPS is great enough.
Harry Sit says
The spreadsheet makes a direct comparison with TIPS in a taxable account in order to quantity the tax deferral benefit of I Bonds. If you have other ways to defer taxes as you suggested, it lowers the threshold to switch. I need to establish first that a threshold exists. Then we can talk about how to lower it.
Moe Howard says
Just to wade in here. I have been buying iBonds for a long time and I use them for fixed piece of my portfolio. (Yes, I have some bond funds). A lot of my iBonds have passed the 5 year mark so are essentially cash. I have this available for emergencies. Unless you need the money, I don’t see a good reason to incur a tax hit. When I do sell some, of course, I will start with the 0% base ones.
Barry says
One thing I never see modeled and wonder about is how living in a high income tax state such as CA ( 9.2%) affects the impact of holding a TIP bond in a taxable vs tax deferred account – the difference being that in the taxable account no state income tax is paid on TIP interest whereas in tax-deferred accounts all returns of any kind are subject to both Fed and State tax when distributed.
Don says
Harry:
Thank you for this analysis. I have also been thinking about trading in old I bonds with
low interest for TIPs. I think yours is the first article I have seen that really makes a quantitative
comparison.
I think there are two potential benefits of I bonds that are not in your calculator. One
is that I bonds do not lose value during deflation. Someone on Bogleheads forum noted
that for 2008-2018, the deflation benefit of I bonds could be considered an average of 0.3%
per year (although it all happened in 2 six month periods). But to quantify the true value
of this effect one would need to assess or guess the frequency with which deflation might
occur in the modern age. The other potential advantage is if we compare I bonds to 10 yr
TIPs or an intermediate term TIPs fund (SCHP) then if
one can buy I bonds with sufficiently high real rates and have the choice to hold onto them
longer than 7-10 yrs one gets to hold onto the high real rate. I think you compare with holding
30 yr TIPs for 22 yr period but I would not want the rate risk associated with that term.
The I bond gives you a choice to hold or cash in depending if rates go up or down.
I think people who bought I bonds before 2008 and have held them have gained substantially
from this. However, my gut feeling is that one would need to have I bond real interest rates
close to 1% than the current 0.5% to have much likelihood of this benefit. So my current
thought is to sell I bonds and only buy TIPs for the present time.
But quantifying both of these potential advantages I bonds
requires speculation on future real rates and I would be interested in your thoughts
about them even if they are qualitative thoughts.
Don
DonK says
One thing not mentioned but may be helpful to some: I-series bonds can be used for your child’s education expenses, e.g. tuition, taking advantage of the education tax exclusion to avoid federal tax on the interest. For those with grown kids who wish to help a Grandchild going to college, transfer (gift) the savings bond to your Child and let them use it to pay the Grandchild’s tuition.
Harry Sit says
If you gift an existing bond to your child by removing yourself as the primary owner of the bond, the interest accrued so far is taxed to you.
“I want to give my bond to someone else. Will I owe taxes?
Yes, you will owe tax on whatever interest the bond has earned up to the time you reissue it to another person. We provide an IRS Form 1099-INT. The new owner will owe taxes on any interest earned from that point forward.”
https://www.treasurydirect.gov/indiv/research/indepth/bond-reissue.htm
Barry says
Harry – Wondering why neither you nor anyone else replied to my Nov 23 comment/question regarding the impact of holding TIPs in a taxable account for those living in states with a high state tax rate. Wondering if I’m missing something because It seems to me to be a question that is likely relevant to many investors. I’m not sure how to analyze it mathematically, but my seat of the pants sense is that the tax deferral advantage of holding any type treasury bond including TIPs in an IRA is going to be offset to some significant degree by the penalty of accruing state tax obligations on the interest, whereas treasuries including TIPs held in a taxable account are exempt from state tax. So in my case living in California, TIPs held in an IRA will eventually be taxed at 31% (22% federal and 9% state), while TIPs held in my taxable account will be taxed annually at 22%. And I’m guessing that an annual tax of 22% is better than a deferred tax of 31%.
FinancialDave says
Barry,
The short answer is that anything held in a taxable account is generally going to be less efficient than the same investment held in an IRA (Roth or Traditional).
Think of it this way – you have probably already paid 31% tax on the funds that went into the taxable account to buy the TIPs, so on day 1 you are equal to your Roth account (and also your traditional IRA because they are equal for same tax rates.) The minute you pay the first tax on anything in your taxable account it loses to the other two forms of tax advantaged accounts.
So in reality you really want to minimize the amount of income producing stocks/bonds in your taxable account as this only makes it less efficient – so put your bonds in your IRA and be happy about two things:
1. Less growth of your IRA which reduces RMDs.
2. No current taxes just because your bonds are throwing off income and thus your taxable account is becoming more like a Roth account. The only types of income you want to see in your taxable account are 100% qualified dividends or LTCG.
Dave
Barry Wasserman says
Dave – Thanks for the reply. I appreciate having someone knowledgable and interested enough to look at this with me. I had to read your reply a couple of times to think it through. Here’s my thought now:
Your key concept, which I understand and agree with, is that the most tax efficient and therefore most desirable income to generate in a taxable account is qualified dividends and LT cap gains. So purely from a tax efficiency point of view, that would mean holding stocks in a taxable account and bonds including TIPs in a tax-deferred account. But of course to do exactly that would mean you are determining your stock/bond allocation based on your tax deferred vs taxable account space instead of the more important factor of risk tolerance for stocks. I’m sure that’s not what you meant, but it’s a crucial and complicating point because, as in my case, I desire to hold a higher allocation of bonds than can fit into my tax-advantaged space.
So that means some form of bonds needs to be in my taxable account, and I’m trying to figure out how to do so most tax efficiently. The first answer might be tax-exempt munis, but for my tax bracket, I prefer the risk/reward of more secure CDs, I-Bonds, and TIPs. So for me the decision is which of those three should be held in the less desirable taxable account. I would now say that I-Bonds are first because that’s the only option anyway and they are already tax-deferred. TIPs would be the second choice because at least you’re avoiding the state tax portion that you’d be accruing in an IRA. The least desirable choice in a taxable account would be CDs or other nominal bonds or bond funds as they are there least tax efficient.
With this train of thought, I’m realizing that my question needed a more complicated answer that factors in each individual’s tax-deferred capacity in relation to their most appropriate stock/bond allocation. Your answer is the conceptual starting point, but not the end point. As somebody wisely said: Investing can and should be kept simple, but taxes never are.
Harry Sit says
Barry – You don’t need to guess whether an annual tax of 22% is better than a deferred tax of 31%. Maybe it’s easier if you break down the decisions.
1) If I have an opportunity to put more money into a tax deferred account, should I do it or should I forego that opportunity and just pay the tax to keep the rest in a taxable account? Answer: I should put more money into the tax deferred account, because in the worst case I just pay the tax and convert to Roth. A Roth is always better than a taxable account.
2) Now that I have the money in the tax deferred account, should I convert to Roth? Answer: It depends on my outlook for taxes in the future. If I don’t convert, it’s because I think it’s better not to convert. In other words the tax deferred account I keep is better than a Roth, and I should think of it as a “super Roth” from this point onward.
3) I need to invest in stocks and bonds (including I bonds, TIPS, and CDs) and I don’t have enough room for everything in my “super Roth” and Roth accounts. What should I leave outside those accounts? Answer: The investments that throw off the least amount of taxes, taking into consideration both the distributed income and the capital gains upon sale. Leaving TIPS outside is better than leaving CDs outside but if I didn’t have to choose between the two I would keep them both inside.
Peter H. says
Barry – back to your original question: have you specifically confirmed that CA taxes distributions of Treasury income from an IRA? I don’t know the answer, but it seems that is not the case in every state. For example, NJ appears to make an exception (see publication linked in this thread https://www.bogleheads.org/forum/viewtopic.php?t=231484). If CA does impose this tax, to come out ahead in the tax-deferred account you’d indeed have to expect your future tax rate (at the time you take distributions) to be lower to account for the state tax. Maybe you will be in a lower bracket, live in a different state, etc. But I think you probably have to make that call ahead of time. It’s not clear to me how a Roth conversion down the road solves this unless CA imposes state tax on a distribution of Treasury income but doesn’t impose it in a conversion.
On the general question of what bonds to hold in a taxable account, TIPS can be less advantageous than nominal Treasuries. It depends on how you own them. In a fund, they are similar. You pay tax on the distributions from the fund. But if you own TIPS directly, you pay tax on the inflation component (increase in principal) even though you don’t receive that increase in cash. While conceptually you can argue that the government taxes inflation in either case, paying tax on income you don’t actually receive means you have to come up with the cash to pay the tax elsewhere. This amounts to an interest-free loan to Uncle Sam. At 2% inflation, a 22% tax rate, with a $100,000 TIPS portfolio the loan is about $440 a year. That’s $440 that isn’t earning you anything.
Harry Sit says
Peter – California taxes IRA distributions all the same. Paying tax on income you don’t receive also happens when you must pay tax on automatically reinvested dividends, which doesn’t make reinvesting dividends a bad thing. The inflation part is automatically reinvested back into the bond. You earn interest on it. You get it when you sell or when the bond matures.
Peter H. says
Harry – you are right. The dividend reinvestment analogy is useful. You effectively get the bond return on the tax payment. My “interest free loan” point was not correct.
Barry Wasserman says
Barry