I-Bonds

(This is a follow-on to my post on worry free investing.)

I-Bonds are savings instruments sold by the US Treasury. In my opinion, these are one of the best long-term savings vehicles. You can get more information from TreasuryDirect, specifically here. I would also highly recommend reading the FAQ.

Why do I like I-Bonds? Here are some of the reasons:

• They preserve the buying power of your money by tracking inflation. The interest rate comprises 2 parts -- a fixed component and a variable component. The fixed part remains fixed for the life of the bond. The variable part adjusts with inflation (or deflation) every 6 months. Even with deflation, the bonds are guaranteed to never pay below 0%.
• The interest on these bonds grows tax deferred till maturity or till they are redeemed, just like an IRA. On redemption, only the accumulated interest will be taxed.
• If redeemed for qualified education expenses, even the interest may be exempt from taxes. This has little applicability for me at this time, so I haven't really looked at the details of this.
• The interest is exempt from state taxes.

What are some of the gotchas?

• You can only buy $10,000 worth of I-Bonds per year via TreasuryDirect.
• You can buy an additional amount of I-Bonds if you overpaid on your federal income taxes.  You would request the refund be used to purchase the I-Bond.  The limit for this is $5000.  Some folks deliberately overpay taxes in order to take advantage of this.
• The fixed rate is very low nowadays. There was a time when the fixed portion of the rate was 4%. Now they usually come in at less than 1%.
• They are not redeemable for the first 12 months after purchase. After that, if redeemed within 5 years there's a 3 month penalty. After 5 years they can be redeemed at any time with no penalty.
• They cannot be held in a tax-deferred account such as a 401(k) or IRA. But it's the safest place to be for money outside of tax-deferred accounts.

How do you buy them?

• Create an account on TreasuryDirect, link a savings or checking account, and transfer money to TreasuryDirect and use it to buy I-Bonds. In this case, the I-Bond will only appear in the TreasuryDirect account online, and there will be no paper trail for the I-Bond. I would recommend printing a copy of the holdings in the account each time a purchase is made.
• If you have overpaid on your federal income taxes, you can request that the refund be made by purchasing a paper I-Bond.

I-Bonds will earn interest for 30 years. After that, paper bonds stop earning interest, while bonds in TreasuryDirect will be redeemed for cash earning 0% in the TreasuryDirect account.

One more thing worth pointing is that if you have a mix of paper bonds and bonds at TreasuryDirect, you can request conversion of the paper bonds to bonds in your TreasuryDirect account.

Update 07/14/2011

According to a recent press release, paper bonds will no longer be sold as of Jan 1, 2012. It remains to be seen whether they increase the purchase limit for electronic purchases.

Update 02/04/2012

According to a press release of Jan 4, 2012, the limit for electronic I-Bonds has been raised from $5,000 per year to $10,000 per year.

Update 03/06/2014

Talked about the option of using federal income tax refund to by a paper I-Bond.

Worry free investing

What led me down the path of worry-free investing was trying to understand and quantify the risk that one takes when they invest in stocks. Conventional wisdom says that if you have money that you won't need for 30 or 40 years, then that should go into stocks, because the long-term returns from stocks handily beat the returns from other investments such as bonds, real-estate, and certificates of deposit (CDs).

What percentage of the portfolio should be in stocks? What percentage in bonds? How much in cash? What if the stock market doesn't deliver its historical returns? How much do you need to invest in order to achieve a certain retirement goal?

I had posted this as a topic for discussion on misc.invest.financial-plan. Someone pointed me to the work of Zvi Bodie, a professor at Boston University. Bodie has co-authored a book titled Worry Free Investing that takes the voodoo out of the above questions. He tells you how you can meet your retirement goals with very conservative investments. In other words, if you're willing to save more, then you really don't need to take on the added risk of investing in the stock market. I am a very conservative investor so the message of the book really resonated with me. The book is out of print, but you can buy it from his website for $5. He also has a bunch of free short videos on this subject.

If your stomach churns with the gyrations in the stock market, this might be an approach worth considering.

In subsequent posts, I have discussed TIPS and I-Bonds which are two of the worry free investments recommended in Bodie's book.