A Happy Surprise for I-Bond Buyers

Question: In the past, I have been very happy with my purchases of I-Bonds, but I know there have been some changes to the purchase limits. Where do things stand now?

Answer: Conservative types can savor some good news for a change: As of Jan. 4, 2012, the Treasury Department announced that for Series I and Series EE savings bonds, individuals would be able to purchase up to $10,000 worth of each type of bond per year, with a maximum amount of $20,000 in both series per taxpayer. Individuals can also buy an additional $5,000 in paper I-bonds with their tax refunds.

Why is this good news? Prior to this announcement, many savings bond buyers had assumed that their purchase amounts would be curtailed to $5,000 in Series I and $5,000 in Series EE bonds per year, for a total of $10,000 in both series per taxpayer per year--half of what they could buy in the past if they split their purchases between paper bonds purchased at banks and electronic bonds purchased directly from TreasuryDirect.gov. That's because the Treasury Department eliminated the direct sale of paper bonds at the end of 2011, but it didn't make the announcement about increased online purchase amounts until a few days into the new year.

Of course, the announcement may not mollify Series I and EE bond buyers entirely because many would prefer to purchase their bonds in paper form. Critics of the electronic bonds bemoan the fact that they don't work as well as paper bonds for gift-givers. Some have even been circulating a petition to get the Treasury to bring back the paper bonds, and the Bogleheads have been having a lively discussion about the elimination of the paper bonds.  

Combining With TIPS
Moreover, investors with large portfolios probably won't be able to build a meaningful bulwark against inflation by using I-Bonds alone, even with the increased purchase limits for bonds purchased electronically. For example, say you have a $1 million portfolio, split equally between stocks and bonds. If you were targeting 30% of your bond portfolio for inflation protection ($150,000), in line with the allocations discussed in this article, it would take you 15 years to amass that stake using I-Bonds alone, assuming current purchase limits stay in effect. Thus, for many investors, it can be a sensible strategy to use I-Bonds in conjunction with Treasury Inflation-Protected Securities.

The two instruments also vary in their tax treatment, which is another reason to combine both TIPS and I-Bonds; you can use the former to provide an element of inflation protection to your tax-sheltered accounts, while the latter fit well within the confines of a taxable account.

Why are I-Bonds best for taxable accounts? Because they don't make regular interest payments and shareholders aren't on the hook for taxes until they sell or the bonds mature. (I-Bonds reach their final maturity 30 years after issuance, but you can cash them in 12 months after purchase. If you redeem an I-Bond within five years of purchasing it, however, you'll forfeit three months' worth of interest.) When you do pocket income from I-Bonds after they mature or you sell, you'll owe federal tax but not state or local.

TIPS, by contrast, are best used to add an element of inflation protection to assets held in a tax-sheltered account like an IRA or 401(k). Unlike I-Bonds investors, TIPS investors pay taxes on the bonds' income payments as well as the inflation adjustment made to their principal values. (In contrast to I-Bonds, whose interest payments are adjusted to keep pace with inflation, TIPS' principal values are adjusted for inflation.)

Understanding the pros and cons of these bonds is essential to employing them well; this article describes and compares I-Bonds and TIPS. Moreover, investors will need to weigh whether they think the bonds are offering sufficient recompense at a given point in time: The most recently issued I-Bonds (issued in November 2011) offered a 0% fixed yield and an inflation adjustment of 3.06%.