What Are I Bonds?

I bonds work as secure government-issued savings vehicles that help your retirement savings keep up with high inflation rates. Every six months, your I bonds interest rate is updated and compounded to reflect the current inflation rates. This means the interest earned within the last six months will added to the principal and start earning interest at the new rate. Simply put, your interest will earn new interest upon itself.

Your I bond will mature at 30 years, but you can cash it in early after a year of ownership. The interest on your I bond is earned as a combination rate, which is calculated based on a fixed rate and an inflation rate.

Both paper and electronic I bonds pay interest all at once. For paper I bonds, this occurs when you cash in the bond. Electronic I bonds pay interest when you cash in the bond, or automatically after 30 years when the bond reaches maturity if you haven’t already cashed in.

You can buy an electronic I bond within your TreasuryDirect account online or buy paper I bonds with your tax refund.

To buy a paper I bond, you don’t need a TreasuryDirect account. You’ll need a Form 8888 to file with your tax return to the IRS.

There are different purchase limits for your I bond, depending on which type you purchase. These limits are the maximum combined limit; you can purchase $10,000 in electronic I bonds and an additional $5,000 in paper I bonds with your tax refund.

There are different steps to redeeming electronic and paper I bonds.

Note that if you hold an electronic I bond and wait until maturity to cash out, you’ll automatically receive your earnings as a Certificate of Indebtedness within your TreasuryDirect account. Otherwise, you can redeem your bond and have the funds directly deposited into your bank account.

The interest you earn on your I bond isn’t subject to state or local income taxes. While your I bond interest is subject to federal income taxes at your normal income tax rate, there are ways to lessen the tax burden.

If you use the interest toward higher education costs, for example, you can avoid paying federal income taxes. However, some restrictions apply to qualify for this tax benefit, including that the owner of the bond must have been at least 24 years old when the bond was issued.

Seek the guidance of a trusted tax professional if you are unsure about the tax implications for your situation.

The main pro with I bonds is their ability to hedge inflation with fluctuating interest rates, while also being fully protected by the U.S. government. This means the government promises to fulfill its financial obligations in a timely manner.

Like any savings vehicle, there are drawbacks to consider. The biggest con is their lower rewards compared to other investment products. Carefully consider each pro and con to determine if an I bond would fit in your retirement plan.

I bonds afford risk-averse investors the opportunity to retain their savings’ purchasing power and diminish inflation risk. In the prevailing interest rate environment, you can make a modest amount of profit with an I bond while still retaining your money’s worth as general costs of goods and services rise.

I bonds may also offer considerably more attractive interest rates than similar financial products, like CDs. Considering their potential to grow this interest for 30 years under favorable market conditions, I bonds are well-suited for investors comfortable with long-term options. But because of the early withdrawal penalties they carry, they may not be the product for you if you’re looking to withdrawal within the first five years.

If your goal is a high reward from your investments, consider I bonds a piece of your retirement portfolio — not the whole pie. Diversifying your portfolio with other retirement income options, like annuities, CDs or stocks, might be better suited to your investment preferences.

These products each carry different levels of risk and reward you can tailor to your preferences. For example, if you want high rewards and can tolerate the associated risks, you might prefer investment options like stocks and index-linked annuities.

Editor Malori Malone contributed to this article.