Year End Moves: I Bonds

This will be a quick post.  I wanted to suggest a few “year end” sort of personal finance moves for the more retail investor types among us.

First, you should max out your tax advantaged accounts.  If you are unable to max them out for 2017, you should increase your contribution in the new year to move in that direction.  In the future, I plan a post about why we should automate our savings. For now, pay yourself first by automatically saving.  If you are not able to max out available tax advantaged accounts, consider increasing your contributions by 100% of any raises you receive (50% if you are particularly strapped for cash).  I will leave the Roth versus Traditional analysis for your consideration.  Go to the MadFientist blog for more information to be used in making your decision.

Second, you should consider buying $10,000 (or whatever you desire your bond allocation for this year to be) in U.S. Treasury Series I savings bonds (“I Bonds”).  There are compelling reasons why investors should purchase zero additional bonds until they have purchased all of the I Bonds the U.S. allows each year.

You are limited to $10,000 per person, per year, in I Bonds purchased electronically via Treasury Direct.  You can also purchase up to $5,000 in additional paper I Bonds with a tax refund (the $5,000 is capped based on each return, so MFJ filers can only get $5,000).  On a side note, I really wish Treasury would bring back paper bonds.  They were a great teaching/gifting tool and it is nice to have a tangible representation of your investment.  For the time being though, you have to go to  http://www.treasurydirect.com to buy the electronic bonds.

So, why bother? Check with your own tax jock, but the interest income on I Bonds is tax deferred. They also offer what is essentially an intermediate yield with the advantage of floating like a short-term bond (based on changes in inflation).

As of publication, they are yielding 2.58%, versus a sub 2.5% yield on the 10 year Treasury Bond. My observation has been that they generally track intermediate term rates. I suppose this could fail to continue in the future under some hypothetical (perhaps involving distortions of intermediate term rates due to foreign, institutional investors), but generally one would expect the impacts of inflation to keep both rates in the same zip code.

I Bonds are also redeemable (at par) after one year, with a 3 month interest accrual penalty if you redeem during years 2-5 (sort of like a bank CD).  After 5 years, there is no penalty.  This makes it possible to use them as your emergency fund, over time.

While $10,000 may not be impactful for some, it seems it could serve many retail investors as their entire bond allocation.  For example, if a married couple managed to save $60K total (in their 401(k) accounts and IRAs) they could then purchase $10K each in I Bonds and have 25% of their total savings allocated to I Bonds.  If they wanted to have a 75%-25% stock-bond allocation they could allocate all of their tax advantaged funds to stocks.  So even individuals saving a relatively large amount of money each year could cover their entire bond allocation with I Bonds.  If a couple wanted to allocate 20% to bonds they could buy the entire $30K in I Bonds (including the max paper bonds) and sock $120K into stocks (apologies for flaunting my lawyer math skills).

The couple would then enjoy an intermediate rate on a floating rate government security, with the benefit of essentially creating additional tax deferral space (consult your tax nerd).  They would also be insulated from the volatility in quotations of  bonds or funds (although they would not have potential negative price correlations).  They also enjoy the ability to redeem after one year, without any drawdown risk.  This allows the I Bonds to serve both as bond allocation and as the source of emergency funds, allowing one to hold less overall cash and fixed income, maximizing exposure to the equity return premium.  But, you can only buy a limited amount each year, so you may need to get cracking for 2017.  Happy Holidays!