I-Bonds boast tax advantages, but purchase limits damp appeal.
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By Christine Benz | 11-14-11 | 06:00 AM | Email Article

When investors think about adding explicit inflation protection to their portfolios, Treasury Inflation-Protected Securities are usually top of mind, as it's easy to obtain exposure to these securities by scooping up a mutual fund or exchange-traded fund. But investors looking to add explicit inflation protection have another option: I-Bonds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

I-Bond Basics
I-Bonds are Treasury bonds that pay a fixed rate of interest as well as another layer of interest that varies with the current inflation rate, as measured by the Consumer Price Index. The inflation adjustment is made twice a year, in May and November. I-Bonds issued Nov. 1, 2011 yield 3.06%, composed of a fixed rate of zero and an inflation adjustment of 3.06%.

I-Bonds are available only to individuals--that's why there are no I-Bond funds--and they're available with face values as low as $25. I-Bonds reach their final maturity 30 years after issuance, but investors can cash them in 12 months after purchase. If you redeem an I-Bond within five years of buying it, however, you'll forfeit three months' worth of interest. In the past, you could buy I-Bonds either as paper securities or electronically, but the Bureau of the Public Debt recently announced that it will discontinue sales of paper savings bonds via financial institutions beginning in 2012.

I-Bonds don't pay you income while you own the bond. Rather, the interest accrues and gets paid out when you sell or the bond matures.

Pros: Because I-Bonds don't make regular interest payments, holders aren't on the hook for any taxes until they sell or the bond matures. So if you plan to buy and hold an I-Bond for many years, it's fine to do so within a taxable account--you won't owe taxes on the accrued interest until you no longer own the bond. When you do pocket income from I-Bonds after they mature or you sell, you'll owe federal tax but not state or local. And those who use I-Bond proceeds to pay for college expenses will be able to skirt federal tax, too, assuming they (and their expenses) meet certain criteria. Because I-Bonds already come with an element of tax deferral, you can't hold them inside an IRA.

Cons: Although I-Bond buyers could scoop up $30,000 in I-Bonds a few years ago, new I-Bond purchases are currently restricted to just $10,000 per year ($5,000 paper, $5,000 electronic) per Social Security number. (That number looks likely to go even lower, to just $5,000 in new I-bond purchases, once paper bonds are no longer available, as this thread on the Bogleheads site discusses.) That purchase limit is a major drawback for larger investors looking to build a meaningful bulwark against inflation.

And because I-Bonds don't make regular interest payments but instead pay you your income when you sell, they're not a good option for those looking to fund any part of their living expenses with the current interest from the bonds.

TIPS Basics
Like I-Bonds, Treasury Inflation-Protected Securities include an element of inflation protection. An important distinction, however, is that TIPS' principal values are adjusted to incorporate the current inflation rate, whereas I-Bonds receive an adjustment in their interest rates to reflect inflation. TIPS' interest payments also vary with the Consumer Price Index, but indirectly; when investors' principal values are adjusted for inflation, their interest payments will also adjust.

Both individuals and other institutions, such as mutual funds, can buy TIPS--they're sold in $100 increments, and are only available in electronic form. TIPS carry terms of five, 10, and 30 years. But in contrast with I-Bonds, which don't change hands in the secondary market (your only options are to wait until the bond matures or redeem it at the Treasury), you can sell a TIPS bond to another investor via a broker. You can buy TIPS directly from the government at TreasuryDirect.gov, or you can buy individual TIPS bonds via your brokerage firm. You can also buy a mutual fund or exchange-traded funds dedicated to TIPS.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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