Series I Bonds are issued by the US Treasury. The are government bonds that have certain characteristics that makes them very attractive in times of high inflation. If we examine some of the benefits and restrictions, we can identify several strategies to maximize the value from these bonds. After an executive 'pros and cons' we will look at the characteristics of the bond, as bonds have many different rules, and then explore several different implementation methods.
Pros and Cons
Low Risk (US Government Bonds).
Illiquid (cannot sell for first 12 months).
High return (forecast to have annualized 9.62% interest in May 2022).
Interest is variable and changes every 6 months.
Tax advantages: State tax free (always) and Federally free in some cases.
Clunky website for electronic bonds, paper bonds may be misplaced.
Education benefits (interest can be tax free federally, subject to AGI limitations).
Harder to integrate into holistic portfolio due to segregation of the account. Cannot be bought or traded on the secondary market.
Kiddie Tax (or low income tax) benefits by election to tax annually.
Requires a good system to know when to sell and whether the sale is taxable or not.
Characteristics of the Bond
Series I Bonds are sold at Face Value and accrue interest monthly for 30 years, or until sold (if sooner). They have two components of interest:
Fixed Rate: remains constant for the lifetime of the bond (currently 0%).
Variable Rate: resets semi-annually based on inflation figures. At time of writing, the annualized fixed rate ending in April 2022 is 7.12%, and the anticipated rate from May will be 9.62%. Interest will accrue monthly, but compound semi-annually.
The two rate types combine to form a 'Composite Rate', which will have three components:
First 6 months Variable Rate
Second 6 months Variable Rate
Power of compounding
For the first 6 months the initial investment of $10,000 is earning $59.33 per month. If you were to log into your Treasurydirect.gov account during this time the value would show only at $10,000. At the 6 month mark, the value increases to $10,356 and the entire amount will now earn at an annualized 9.62%. This results in earning $498.12 for the second 6 months, rather than $10,000 at (9.62% /2) earning only $481.00. Note that if you buy in April, you would get the April 7.12% for the first 6 months, and then would recieve the May 9.62% for the next 6 months, whereas if you buy in May, you get 9.62% for the first 6 months, and 'whatever the rate is in the future' for the next 6 months.
Acquisition Method Electronic Bonds
Purchase at Face Value (Par) at Treasurydirect.gov
$25 to $10,000 (penny increments). Duration of 30 years.
Limit of $10,000 per Tax ID (SSN or EIN) per year.
Acquisiton Method Paper Bonds
Purchase at Face Value (Par) via tax refund
$50 to $1,000 denominations. Duration of 30 years.
Limit of $5,000 per Tax ID (SSN) per year.
Two parts: Fixed Rate and 6-month Variable Rate
Fixed Rate currently 0% Variable Rate from May 9.62% (annualized)
Fixed Rate remains in place for duration. Variable Rate resets after 6-months.
Tax Treatment (Basic)
Taxable at Federal Level Tax Free at State Level
Tax is always 0% at the State level, education benefits exist (see below). By default, tax will accrue annually, but be recognized on disposition (or maturity).
Tax would be generated when bonds are sold, or annually if elected.
Tax Treatment (Education Benefit)
Interest can be tax free (Federal level) if used to pay for qualified education expenses.
May increase effective rate of return and could replace or augment 529 plan contributions.
AGI limitations exist on the amount of excluded interest. Calculated on IRS Form 8815
Tax Treatment (Kiddie Tax Benefit)
Taxpayer may elect to recognize tax annually rather than at disposition.
For child owners, this could create tax free rate of return. Once elected, must continue until disposition. Election may be made at any time.
Awareness would be required to ensure that the taxpayer doesn't report the interest twice.
Penalties and Restrictions
First Year cannot sell bond. Year 2 to 5 selling will forfeit 3 months of interest.
12 month lockup means that this cannot be an emergency fund source in year 1.
3-month interest penalty is less important unless near to 5 year deadline.
Strategies to maximize value
The initial strategy is to apply for the maximum amount of Series I Bonds, $10,000 per SSN, plus $5,000 from your tax return. Here are some ideas to stretch the concepts further.
Superfunding (how far can you push the limits?)
It would seem that the greatest restriction on purchasing Series I Bonds is not that you are limited to $10,000 per SSN, and rather is derived from your own approach to risk and ethics. Ethical questions are best solved at the individual level, providing that the strategy is legally sound.
From the explanation on the Treasurydirect.gov website, the limits are set to $10,000 per person plus $5,000 per tax return. There are a couple of exceptions:
Bonds bought as gifts can be stored in a 'gift box'. This allows you to store multiple purchases (but may require retitling later if linked to different SSNs). Note that you may hold a Bond in the Gift Box for up to 30 years....
Bonds may be bought by Businesses and Trusts. This allows a person who is the owner (or beneficiary) of such an entity to hold more than $10,000.
It is interesting to note that an unincorporated business with merely a DBA status is eligible to own a bond. Based on the way that the system tends to track ownership, it would seem that you would need an EIN for each business or DBA that is holding the bonds.
How much is too much?
I was initially skeptical about using entities to bypass the annual limit, but as a person who owns several (legitimate) businesses I can see the value in each of them holding Series I Bonds to protect the purchasing power of the business and help ensure that the business may cover expenses that are subject to inflation. The fact that there is an option for an entity as casually designed as a DBA reinforces the notion that you may buy a bond both for yourself, and that a business may buy one for itself. The fact that you have similar beneficial ownership is arguable, as the asset is owned by the entity (and may be transferred by the sale of the entity).
Impact on Basis
A benefit of the business holding the bond is that the asset remains in the business, thus impacting basis. For example, if an S Corp owner were to withdraw $10,000 to buy a bond in their (individual) name it would be a distribution of capital (an owners draw). Whereas, if the owner buys from the business, the Series I Bond is carried on the balance sheet of the entity, affording the same benefits to the owner without impacting draw.
To an. S Corp owner who could only afford one bond, buying it within the business and carrying on the balance sheet would be preferable. To a person who could afford more than one bond, this is a viable approach.
Trust and Estate
I have seen people attempting to purchase in this manner:
Trust (Revocable) For Spouse 1
Trust (Revocable) For Spouse 2
Personal Name Spouse 1
Personal Name Spouse 1
Total of $40,000. The issue here (other than requiring multiple EINs) is that this strategy conflicts with the approach of holding all assets within the Revocable Trust. While this can be acceptable with transfer on death (IE with a beneficiary designation) it does increase the risk of a mistake in estate planning, and possibly reintroducing probate concerns.
Since both Individual Ownership and Business ownership can create this estate complication, it is something to factor in for those seeking more than $10,000 per SSN, per year.
Kids: Kiddie Tax vs Education Benefits
One idea is to simple buy the Series I Bonds for everyone with an SSN in the household (parents and children). There are two interesting things when considering the kids:
There is an election that may be made to receive the income annually (the default is to receive it on maturity or sale). If you buy in the childs name, it is possible that a lot of interest will be tax free. Here, the child may earn $2,200 tax free. If you were to buy a bond for a young child, they could elect to take this interest annually, but pay little to no federal tax. As standard, the Series I Bond is exempt for State tax (as a Treasury Bond) and therefore the majority growth could be tax free, depending on how quickly the interest compounds.
It is worth noting that a child who uses a Series I Bond for education in their own name (IE, that they were gifted) may not claim the education benefits that a parent may claim. On the other hand, if the parent owns the bond, and redeems it in the same year they incur education costs, they can exclude the interest that is created on the redemption of the bond.
Keep in mind that AGI limits apply to this parental benefit, so for those in higher income brackets a better strategy might be to leverage the Kiddie Tax, and then have the child liquidate the bonds prior to FAFSA evaluation times.
What if you can't afford it? Is there debt arbitrage?
There's an old adage in the financial industry called the 3-6-3 rule. In this, a banker is happy to borrow at 3%, lend it at 6%, and be on the golf course by 3pm. This is a fantastic concept which many people would do well to consider. The key to this is that there is perceived to be equal risk in the borrowing and lending, therefore we have a risk adjusted profit. Where others make a mistake here is when they try to borrow (mortgage, margin, etc) an invest in an unequally risked product. You see this when people say that they would rather invest in the stock market than pay off their mortgage.
The 401(k) Loan (example)
Typically, you may borrow 50% (capped at 50,000) from your 401(k), to be repaid over no longer than 5 years. You must pay interest at a rate (that is fuzzily undefined by the IRS) of around WSJ Prime plus x (perhaps 50-100bps). This interest rate would be around 4.5% today (3.5% prime plus 1%).
Removing equity risk from the equation, your would pay around $450 to earn close to $854.12. Though, we should keep in mind if you lose your job your loans can be instantly due for repayment, which could cause conflicts with the 12 month lockup on the Series I Bond. The loan is an extreme example, but it is also a good example of shifting the risk-free rate of return that would otherwise be a component of the portfolio within the 401(k). We could argue that the profit is subject to tax, but that also varies on circumstance (EG a person might borrow from their 401(k) to fund a child's Series I Bond and pay no tax at the Kiddie tax level).
A replacement for the 529?
Perhaps not entirely. A 529 has FAFSA benefits when calculating assets, but it might be a component of college savings. Rather than just a 529 we might instead have:
529 for 60% of costs
Series I Bonds (Parental owner) for 20% (when AGI limits are favorable)
Series I Bonds (Parental owner) for 20% (when Kiddie tax rules are favorable)
Individual circumstances can influence how to weight these allocations, and while there is a negative aspect to the FAFSA calculation, holding a mix of funds for college reduces the concerns about overfunding a plan for a child that might not need a fully funded education (they may have a scholarship, etc).
IRS Form 8815deals with excluding Series I Bonds interest (for education related benefits).