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.