Emergency Funds and the (Almost) Risk-Free I Bond

Your Rainy Day - or emergency fund - needs to be liquid, but it doesn't have to be shoved under the mattress where it can't earn a penny in interest. But does it have to be tucked away in a savings account where inflation gobbles up the minuscule yield you get through the bank's low interest rate? I have found a better alternative...the I Bond. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Liquid Rainy Days

Over the years, I've suggested that folks set aside money (a minimum of 3-6 months of equivalent salary) to handle unforeseen emergency expenditures – primarily to avoid having to tap into retirement funds. And generally speaking, I suggest that folks place this money in safe - but liquid - assets… like crypto currency. Just kidding!

I do emphasize safety and liquidity for your Rainy Day funds, like an FDIC-insured bank savings account. But I always do so with a twinge of guilt because those bank savings accounts are like thieves in the night, paying just 1/10 to 1/15 of a percent interest on your money. In short, after inflation, they pay not just nothing but less than nothing in terms of purchasing power. Today, I want to open a dialogue about a little-used option which is an almost (though not entirely) risk-free place for your emergency funds...I Bonds.

I Whats?

Series I Savings Bonds (I Bonds, as I call them) were devised to help smaller investors deal with the consequences of inflation…and as a possible alternative to those low bank savings rates. I Bonds have a fixed rate that remains the same for the 30-year life of the bond PLUS an inflation rate that adjusts semi-annually (currently 3.54%, which applies to I Bonds issued until November 1, 2021). At that point…and at later 6-month increments…that latter rate resets, that is, unless the “official” government rate of inflation remains the same.

I Bonds are only available online through the U.S. government’s site TreasuryDirect.gov or in paper form using your federal tax income refund. In short, you can only buy paper I Bonds when filing a federal income tax return (minimum purchase $50). Otherwise, you buy them online via Treasury Direct, minimum purchase $25 (including through payroll direct deposit).

How Are Bonds Liquid?

Yeah, I know. I preach keeping emergency funds in a “highly liquid” place. The I Bond's 30-year term doesn’t sound liquid at all. You’re not alone if you're wary about that factoid. I Bonds can’t be sold until 12 months after purchase so are not liquid that first year. Further, if you redeem them before you’ve owned them for five years, you’ll forfeit three months' interest, which impacts your yield a bit. But you CAN redeem them after 12 months. and - perhaps best of all - the government pays interest for 30 years if you keep your money there and protects you from both inflation and deflation.

And don't worry when those circling financial wazoo buzzards appear puzzled when the subject of I Bonds is brought up. Their confusion is related to the fact that they have no incentive to sell ‘em. In short, they have no opportunity to add on to the cost of the I Bond.

I Bonds and TIPS

I Bonds are available exclusively from the U.S. government with a government guarantee that your original capital investment plus any increase in the cost of living during your ownership is secure. And, no, they aren’t Treasury Inflation-Protected Securities (TIPS)…but similar.

Both I Bonds and TIPS are inflation-related government bonds that offer principal and purchasing power protection. They both combat inflation risks, but in subtly different ways. Currently, you can only buy $10,000 of I Bonds per individual family member during a calendar year with a $25 minimum per bond. An additional $5,000 can be acquired if you direct your tax refund toward the purchase. Old Sam likes to hang onto every dollar he can, even if temporarily.

On the flip side, you can buy up to $5 million in TIPS at any single auction using Treasury Direct. I myself prefer the more doable minimum purchase of I Bonds.

Tax Treatment

Interest on I Bonds is subject to federal income tax…no surprise there…but typically they are exempt from state and local taxes. NOTE: interest is added to the value of I Bonds and only taxed upon redemption. And as mentioned, should deflation occur, the value of an I Bond never goes below that bond's value in the prior month.

In short, any upward inflation adjustments already received can't be eroded by later occurring deflation.

Digging Into Details

I Bond rates are adjusted each May and November, and those rates are the sum of the fixed rate (guaranteed for the 30-year bond life) and the variable inflation-indexed rate, which adjusts semiannually. As of May 2021, the fixed rate was 0.00% and the variable rate was 3.54%.

The variable portion of an I Bond's interest rate is set every six months, based on the consumer price index. The CPI is the U.S. government's measurement of price changes in a typical "basket" of goods and services bought by urban consumers. The basket represents the prices of a cross-section of goods and services commonly bought by urban households.This variable rate is paid out in addition to a fixed rate (if any), which is determined when the bond is issued.

Again, although they are 30-year bonds, you CAN redeem them after 12 months. An example. If you had bought an I Bond at the current fixed rate of 0.00% and the variable rate of 3.54%, and if you needed to sell it after that one-year required holding period, you will have earned 2.65% (3.54% less the three month penalty of .885%), assuming the variable rate doesn’t change. Sounds a whole lot better than your local bank’s savings rate of 1/5 of 1%, doesn’t it?...about 18 times better.

Try This on for Size

How about this as a starter. Initially, place 50% your emergency funds in an FDIC-insured bank savings account and the other 50% in I bonds. After one year, the I Bond half of your money is now immediately available, allowing you to buy I bonds with the other 50%. Yes, you’re subject to the 3 months of forfeiture, but look at the HUGE improvement in yield on those I-Bond invested dollars.

For risk averse folks like me but who don’t wish to store their dollars with a bank at a loss - a pitiable interest rate of 0.15% eroded by inflation rates of 2%...3% …4%...or more - consider negotiating a line of credit with your friendly banker (perhaps using your I Bonds as collateral) if you happen to need some quick money. During this first year of exposure, try to avoid a bank maintenance fee on the hopefully untapped credit line and a variable interest rate during its term. For you risk takers, knowing that government-guaranteed I Bonds offer some assurances against the high probability that some of your other bets will sour will provide comfort. Give it some thought.

In Sum

Without question, I Bonds aren’t as liquid as money in a bank savings account, a money market fund, or short-term treasury bills (and emergency funds need to be quickly available). But where there is a will, there is a way.

And considering the HUGE increase in yield with little additional risk, it just might be worth the effort.