Financial advisors say that everyone should have at least 6 months of living expenses
in an emergency fund that can be quickly accessed to pay unexpected expenses.
But quick access means that the money is usually held in a savings or checking account earning
little or no interest.
I bonds are a better way to hold your emergency fund.
Free of state and local taxes, and no federal tax until the bonds are redeemed, interest
is usually much higher than offered by a savings account and is compounded twice annually tax-free.
Moreover, the funds are as safe as a savings account, guaranteed by the federal government.
Even though the money is safe, guaranteed never to lose value, some I bonds do as well
or better than the stock market over an extended time.
For instance, I bonds issued in May 2000 earned a 259% return, equal to 12% compounded annually,
from the issue date to April 2022.
This is more than twice the return earned by a fund based on the S&P 500 index over
the same time period.
This is a great return for an asset that is guaranteed against default and has no interest
rate risk, unlike most other bonds.
Although I bonds provide a great return, there are some problems with using I bonds as an
emergency fund.
This video will show how to overcome those problems.
At the end of this video, I will show how you can progressively increase your investment
return on I bonds.
This video assumes that you have a basic knowledge of I bonds.
If you do not, then check out my complete video, I Bonds in Depth.
The link is provided in the description.
An emergency fund is a cash reserve that’s specifically set aside for unplanned expenses
or financial emergencies, such as car repairs, home repairs, medical bills, or loss of income.
It can also cover periods of unemployment or disability, which can last for months.
Disability can be very expensive and is more common than what most people think.
Many people rely on credit cards or loans,
often at high-interest rates, to handle emergencies.
The amount that should be kept in an emergency fund depends on your particular circumstances:
the type of job you have, your regularity of income, and your expenses.
Many financial advisors recommend having enough money to pay for at least 6 months of living
expenses.
But you should keep more if your income is unstable or if you have health issues.
While a savings account provides immediate
funds for emergencies, it has several disadvantages.
Interest rates are usually low, often below 1%.
State and federal taxes must be paid on the interest every year.
By contrast, I bonds usually pay a much higher rate of interest and the interest is not subject
to state or local taxes.
Furthermore, federal taxes must be paid only when the bonds are redeemed.
The interest on I bonds is compounded semiannually,
which means that the value of the I bonds
grows tax-free, which leads to faster growth than if the interest were taxable annually.
You can also specify beneficiaries who will receive the proceeds outside of probate.
An emergency fund must be liquid, which is usually achieved by keeping money in a savings
or checking account.
Investments should not be a source of emergency funding, since you may be forced to sell at
a loss or to forfeit future profits.
Money in a bank account can quickly be used to pay bills and money held in banks is insured
against loss by the Federal Deposit Insurance Corporation (FDIC), which is why they are
often used.
But there is a way to gain the advantages of I bonds and the liquidity of a bank account.
One drawback of US savings bonds is that they cannot be redeemed before 1 year and you forfeit
3 months of interest if the bond is redeemed before 5 years of the issue date.
There are 2 exceptions that may allow redemption before 1 year.
You would have to contact TreasuryDirect to use either exception.
You would probably not receive any interest if redeemed before 1 year.
Bonds can be cashed out before 1 year if you live in a federally declared disaster zone.
Another exception is financial hardship.
However, I can find no information on the specific requirements to qualify for the financial
hardship exception, whether they have criteria to judge the degree of financial hardship
and what proof, if any, you would have to give.
I would guess that simply explaining your situation would work, but I cannot find anything
on TreasuryDirect’s website that provides more details, so do not depend on using this
exception.
A better way to avoid redeeming your bonds before 1 year is to keep your emergency fund
in a savings account until you can replace the funds with redeemable I bonds.
However, it would be beneficial to keep some money in a bank account to make quick payments.
Redeeming your bonds in a TreasuryDirect account may take up to 2 business days, then up to
3 more business days to transfer the money to a savings or checking account so that the
money can be used to pay bills.
So it may take up to 5 business days after redeeming your bonds before you have the money
to spend.
Note that bond redemptions are taxable in the year of redemption.
To understand how you can improve your investment and to see one drawback to I bonds, you must
understand how the composite interest rate is calculated.
The composite rate is determined by 2 components: a fixed rate and a variable rate, based on
inflation.
Both the fixed rate and the variable rate on new bonds is set every May and November.
Once a bond is issued, the fixed rate never changes over the 30-year life of that bond,
but the variable rate is reset every 6 months from the issue date, based on the most recent
inflation data.
Here, you can see how the composite rate is calculated for I bonds issued from May to
October 2022.
Note that since the fixed rate is 0, the composite rate is based only on the semiannual inflation
rate multiplied by 2.
This is an example of a calculation when the fixed rate was 3.6%.
You can see that, during periods of high inflation,
a high fixed rate can result in a very high
composite rate.
One drawback of I bonds is that there may be some periods when it pays no interest.
If you look at how the composite rate is calculated,
the fixed rate is added to the variable rate,
but sometimes, during periods of deflation, the variable rate may be negative, which will
subtract from the fixed rate, though this rarely happens.
This example shows the calculation when the inflation rate was -2.78% in May 2009.
Even with a fixed rate as high as 3.6%, the composite rate is still less than 0.
But if the sum of the fixed rate and the variable rate is less than 0, then the interest rate
is 0.
Savings bonds never lose value.
You just do not earn any interest for that 6-month period.
You can lock in greater earnings by buying more I bonds when the fixed rate increases.
Even though the variable rate will be low when the fixed rate is higher, it is beneficial
to lock in the fixed rate to benefit from a higher composite rate later, when inflation
increases, as it does periodically.
You can then redeem your other bonds to invest elsewhere or to buy more I bonds with the
new higher fixed rate.
Redeeming your bonds may incur federal taxes in the year of redemption, but federal taxes
can be reduced or eliminated by using the proceeds to pay for qualified higher educational
expenses or for contributions to a Coverdell Education Savings Account or a 529 plan.
Check out my in-depth video on I bonds for more information.
When will the fixed rate increase?
I could not find any information on how the fixed rate is determined.
Based on historical rates, I believe that the major factors affecting the fixed rate
are the federal funds rate and the inflation rate.
The federal funds rate is set by the Federal Reserve and is often raised to combat inflation,
so it tends to be high when inflation is high.
In the past, the fixed rate was higher when inflation was low and the fed funds rate was
high, as you can see in the lighter portions of this chart.
But if inflation is high, then the fixed rate may still be low or 0, even when the fed funds
rate was high, as you can see in the graph for 2008 and 2016 to 2017.
So I believe the fixed rate is adjusted to make savings bonds competitive with other
interest-paying investments.
This graph more clearly shows the relationship between the fed funds rate and the fixed rate.
The fixed rate may soon rise if the Fed continues to raise interest rates and inflation subsides.
Then it would be a good time to buy more bonds!
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