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I recently ran across an article about where to park extra cash that mentioned US I Bonds. I had never heard of them before. How do they work? Limitations or rules? Really tax free?

I've had EE US savings bonds from my grandparents (seems to be pretty common), which have pretty sad returns, and I never really thought about them as savings account.

But this page says I Bonds are currently paying 4.6% which seems too good to be true based on current rates on anything else as safe.

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The main appeal of an I-bond is that the return rate is indexed for inflation. The rate is a combination of a fixed rate (which is generally based on prevailing interest rates, and is currently VERY low) and floating portion which is based on the current rate of inflation and adjusted every 6 months.. that inflation rate is where the current return on the I-bonds is coming from right now, and was due to a pretty fortuitous timing of when they set those rates and a sort of inflation hiccup that happened around the same time. BTW if the inflation rate is zero, or negative at the next repricing period for those bonds, the yeild would drop to zero percent. (ibonds will never have a negative yeild)

TIPS (Treasury Inflation Protected Securities) are similar in many ways to I-Bonds and are another means of gaining inflation protection. The mechanics are a little different, but the net effect still amounts to a base rate, plus an adjustment for inflation. See this treasurydirect page to understand the differences between them.

To gain bit of perspective you might want to view historical inflation rates.

People who have been really happy with I-bonds, are generally those who bought them when they had higher base rates than the current ones.

I-Bonds are not 'tax free' however they can be 'tax deferred'. (depends on what you do with the interest) This means they can grow in value tax free (giving you a higher rate of return than if you had to pay taxes every year on the interest) but you will still end up paying taxes down the road (very similar to a 401K, or standard IRA).. BTW, this means there is ZERO value in putting these inside a IRA or 401K (TIPS might be a better choice in that case)

Are they for you? Depends on what you think will happen with Inflation. There are voices in the market that insist that all the money being pumped into the system right now to foster a recovery will cause insane crazy run-away inflation down the road. (others feel that will only happen if the fed isn't on the ball and doesn't raise rates fast enough once things turn around). It should be noted that many such talking-heads have been forcasting runaway inflation very soon for a few years how, and it's yet to come true. Anyone that bet on high inflation 2 years ago, has been mostly disappointed so far.

To the extent you fear inflation might consume a lot of your hard earned funds or just want a Hedge against inflation, then i-bonds and TIPS are an excellent way to mitigate that risk. However, with a zero base rate right now, if you invest in these, you are basically betting everything on inflation, and if it stays low, you'll be sorry. (however if it spikes, you'll be sitting pretty)

If you feel the current Fed leadership are 'on the ball' and won't let inflation get out of control, don't feel any need to 'hedge' that bet, then you are likely to want to invest somewhere else.

  • Excellent commentary on why you might want one, or not, with respect to inflation. – Jay Aug 9 '11 at 19:13
  • yeah if inflation goes nuts and the market doesn't keep up, i-bonds and tips are likely to get VERY popular. – Chuck van der Linden Aug 9 '11 at 19:27
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After posting, I found this page, which kind of answers my own question, but still like to see some personal experience from anyone, in case the faq isn't accurate.

http://www.treasurydirect.gov/indiv/products/prod_ibonds_glance.htm

Some key points:

  • Can purchase various denominations from $50 up to $5000 at face value.
  • Maximum purchase $5000/yr (I assume per person.)
  • Interest is inflation adjusted every 6 months, currently at 4.6%
  • Interest is Tax deferred (so still taxable when redeemed) for federal income, but NOT state income, unless it's used for a "qualifying education expense in the year it's redeemed."
  • Must be held at least 1 year, and if redeemed before 5 years, there is a 3 month interest penalty.
  • Interest earned for 30 years.

So in short, it's about the same a 5+ year CD with better than market rates, if my understanding is correct.

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