$tarrBuck Report for October 22, 2006: I-bonds: Beating Inflation One Dollar at a Time

                                                                                                        October 22, 2006

$tarrBuck Report for October 22, 2006:  I-bonds:  Beating Inflation One Dollar at a Time
by R. M. Starr

Your favorite uncle, Uncle Sam at the US Treasury, has a deal for you, inflation-indexed savings bonds, I-bonds.

What is an I-bond?
An I-bond is a kind of US Savings bond.  It’s a loan from you to the US government.  You can collect the money the government owes you anytime after 12 months from purchase (there is a 3-month interest penalty for cashing them in the first 5 years).    The bond earns interest regularly.  More important, the value of the bond is adjusted every six months for inflation.

How does inflation indexing work?
An I-bond pays you interest in two parts.  There’s an annual coupon rate (the guaranteed yield on the bond, currently at 1.4% annual rate paid semi-annually) and an inflation adjustment.   The inflation adjustment is currently at a 1% annual rate (falling gasoline prices don’t generate much inflation). Every six months the Treasury figures out how much inflation there has been over the last six months and increases the value of the bond by that percentage  (measured as the Consumer Price Index for urban consumers). The combined rate is now 2.41%, annual rate, paid in half portions and adjusted every six months.   Your I-bond’s purchasing power is always safe from inflation.

Where can I buy one?
Any bank can sell you an I-bond.   If you’d like a paperless I-bond you can buy it on the web from the Treasury, at http://www.treasurydirect.gov/

What about taxes on an I-bond?
I-bond earnings are state income tax-exempt.  You pay US income taxes on all of the yield on your I-bonds, both the coupon interest and inflation adjustment.  But you don’t have to pay your taxes right away.  You can defer income taxes on your I-bond earnings until you cash them in or they mature (30 years from purchase).  While the taxes are deferred, the value of the bonds grows as you earn interest on all of the accumulated interest from the past.  Financiers call this the miracle of compound interest.

What if inflation rates go up?
You’re covered.  Inflation-indexing means that you never lose purchasing power.   The dollar value of your I-bond goes up with inflation.

What if inflation rates go down, really down, deflation?
You’re covered.  Deflation is very rare — we haven’t seen it in the USA in 65 years.  But if it happens, big time, so that the combined coupon plus inflation rate on your I-bond is less than zero — the dollar value of your I-bonds stays fixed in place until the combined coupon plus inflation rate goes above zero again and your accumulation continues.

What if interest rates go down?
You’re covered!  Your coupon rate is locked in when you buy your I-bond.

What if interest rates go up?
Do the math.  The old coupon rate on your I-bonds was locked in when you bought them.   If interest rates have gone up a lot since then, maybe it makes sense to cash the old ones in, pay the taxes, and buy some new ones with their higher rate.

Where can I find out more?
One of the world’s great webpages, from the US Treasury: http://www.publicdebt.treas.gov/sav/sbiinvst.htm

(c) Copyright 2006 by R. M. Starr

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