Feb 2023 newsletter

Hello,

As promised, this month's newsletter will answer one of my client's questions, "Should I buy I-bonds?"

To get a complete answer, you will have to read a long piece of writing as usual. 😊

I bonds- what you should know about before buying them

Bonds are fixed securities. Stocks are variable securities. 

There are so many kinds of bonds out there, issued by federal, state, or city governments, and corporations. 

According to Ric Edelman's book "The Truth About Money- Everything You Need to Know About Money" 4th edition, investors use bonds to produce income because the bond issuers have to pay back the bondholders the principal with its interest. So bonds are also named "fixed-income securities".

CDs are also considered bonds because you lend the bank your money (yes, the bank says that you deposit your money). After a while, you want your principal back with the interest. However, CDs are mostly issued by banks and brokerage firms. 

Investopedia

Liquidity

You can't access the money you put in I Bonds for 12 months. In another word, it is illiquid in the first year. So you should use the money you may not need for the whole 12 months in case of an emergency.

It's ideal if you can hold them for more than 5 years before selling them. If you sell I bonds before 5 years, you will lose 3 months of interest. 

It is a good way to protect the value of the principal money but may not be a good place for you to park your emergency fund.

The Street

I-bonds rate:

I-bonds are one of many securities issued by the U.S Government, categorized as savings bonds. You can only buy I-bonds directly on the website Treasury Direct dot gov. 

I-bonds - or inflation-linked saving bonds are designed to help bond investors keep pace with inflation. 

With an I bond, you earn a combined interest which comes in 2 parts:

- a fixed interest rate set for the bond's life when you buy it. I saw that the fixed rate ranged from 0% to 0.5%, which is so low, compared to other bonds. Now the fixed rate is 0.4%

- a variable rate that is reset every 6 months based on changes in the Consumer Price Index. 

Because the inflation rate for I bonds since November 2022 was 3.24%, the composite rate for I bonds from November 2022 to April 2023 is now 6.89%. You can learn how the government gets that composite rate here. 

U.S Inflation Calculator

In comparison, the 6-month term CD rate now ranges from 3.8% to 4.5%. Therefore, a lot of people think that buying I bonds is a better option for your money. I don't like vague guessing so I have to put them in numbers to compare. 

State Taxation

CDs and I bonds are taxed differently, so to make an apple-to-apple comparison, you have to determine the bond's taxable-equivalent yield.

You have to pay federal and state income tax for CDs' interest every year while I-bonds interest is exempt from state and local tax. 

If you live in the states which tax your income, I-bonds can be considered state-income tax-free while CDs are still state-income taxable. So, CDs' 4.5% is the before-tax rate while the I bonds' rate is after-tax. 

My Google Sheet to calculate the Taxable Equivalent Yield.

I'm living in Virginia, so I put the Virginia state income tax rate in the Google sheet here. With my income now, my state tax rate is 5.75%. The I bonds rate now is 6.89%, so a taxable investment must have an interest rate of 7.31% to be equivalent to I bonds. 

In another word, 6-month term CDs must have a rate higher than 7.31% to beat I-bonds now. I bonds win. 

Please notice that after 6 months, the I-bonds rate is reset. If the I bonds rate is set to 3.54% this May (this rate was from May to Oct 2021), and the 6-month term CDs rate is still 4.45%, I should buy CDs because 4.45% is higher than the equivalent rate of 3.76%. Because I can't sell I-bonds before 12 months,  I earn less interest during this second 6-month period on the I Bonds which I bought last November, compared to 6-month term CDs. I bonds lose this time.

Federal Taxation

You have to pay Federal income tax for I Bonds interest at your income tax rate.  

If your marginal tax rate is 22%, your I bonds earnings are taxed at 22%.

You have a choice to pay taxes annually or you can put them off until you redeem them. 

You can avoid Federal taxation by cashing out the I bonds to pay for qualified higher education expenses like tuition, student fees, and equipment. It means you choose to defer the tax until you cash out. 

Some people may think that it is a good idea to use I bonds as a tax-saving tool for education expenses. In my opinion, it's just a supplement along with other financial tools for college savings because room, board, transportation, and books do not qualify for tax exclusion. Moreover, you have to satisfy all 6 conditions to use this for tax-free college expenses. 

You must be cautious to handle federal income tax this way. Treasury Direct listed some rules for you to think over before using this method. I list here just 3 of the 6 conditions to satisfy: 

1 - Your income limit for the year. 

This amount is set annually by IRS. In 2023, the phase-out begins at the threshold of $137,800 and finishes at the ceiling of $167,800 or more. 

For example, if I want to cash out I bonds to pay for my kid's college tuition, my modified adjusted gross income (MAGI) must be lower than $137,800 for joint filers. 

So if my MAGI now is $140,000, I still have to pay a portion of the tax. If my MAGI is $172,000, I pay tax for all of the redemption proceeds.  

taxnotes

2- Dependent status on the tax return.

If your MAGI qualifies the restrictions, you can only use the I bonds issued under your name to pay for yourself, your spouse, your child, or someone you list as a dependent on your federal income tax return. Therefore, a grandparent can't cash out I-bonds to pay for the grandchild who is not listed as dependent on their federal tax return.

3- The age restriction. 

The person named on the bond must be 24 years or older. I saw that a lot of people are advised to buy I bonds under their children's names. They say that if you have 4 people with SSNs in your family, you can buy $40,000 of I bonds. But if your children were under 24 years old when the I bonds were issued under their names, the cash-out proceeds are not excluded from the federal income tax return even years later. Therefore, if you want to buy I bonds to later get this tax exclusion for a child's higher education, you must register the bonds in your name, not the child's.

Math doesn't lie

So, is it good to use I bonds to save for college?

I had to put everything in numbers to see clearly. 

First, I have to buy I-bonds under my or my spouse's name to redeem them for my kid's college tuition.

Second, I have to keep those I bonds for more than 5 years so that I won't lose 3 months of interest as penalties if I cash out before year 5.

For the math I did, I use the historical chart of Treasury Direct to calculate. I assumed that I have bought $2,500 of I bonds every 6 months since May 2011. I didn't know how to calculate some variables, but this sheet can still show me the number I want to see.

After 11 years, my total principal is $55,000. The total value I got after 11 years can be $91,089. It seems a good investment.

$55,000 after 11 years has lost its purchasing power due to inflation. I used the CPI inflation calculator to see that $55,000 in 2011 equals $74,716 in 2023. College expenses rise every year. You want the money you save for 11 years to be able to pay for college tuition for your children after those years. 

Education Data

If my tax rate is 22% in 2023, and my MAGI is under $137,800, then the amount of $91,086 can be used to pay college tuition for my kid in 2023 totally tax-free.

Take $74,716 out of $91,086, I got $16,373 returns after 11 years. Not bad, right?

But if you don't satisfy the conditions of tax exclusion, you have to pay the accrued amount of Federal tax which is about $6,840 for 11 years. Then your earnings are now $9,533. 

This seems ideal. 

Look deeper into the numbers. 

I can't cash out the total $91,089 value of I bonds because I can't access the I bonds I bought for under a year. So I can only redeem the bonds I bought before May 2022 and lose 3 months of interest for the other bonds I have under 5 years. So I can redeem about $72,958, which is lower than the inflated amount of $55,000, i.e. $74,716. Notice that the penalties were not taken out of the amount of $72,958 yet.

So, if you don't calculate inflation, you may be tricked by the performance. 

I bond's job is to hedge your money from inflation. In another word, your principal money value can have the same power of purchase after an amount of time. 

If you have no ideas where to invest your money, I bonds can be a good option to keep your money safe from inflation and theft. Ideally, you should buy and maintain I bonds for about 10 years before cashing out for college tuition so that you don't need to touch I bonds that are under 5 years. 

(And I think all investments need at least 10 years for the money to compound and have good returns.)

You may not want to cash out a big number like I did above. Cashing out small increments of I bonds can help you maximize the tax exclusion for qualifying education expenses. 

You can use the Google Sheet link here to see the calculation more clearly. You can copy the sheets into your own Google sheets and change the numbers you want. I welcome all comments. 

I hope my long answer can help you make your own decisions about whether or not to buy I bonds.

If you have any questions, I am here to help.

Ha Le, CRPC™

Milky Way Retirement

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