When to Stop Buying I Bonds or Cash Out and Buy TIPS

[Rewritten on November 3, 2022. Older comments were from 2018 when this same issue came up.]

The Treasury Department announced rates for new I Bonds sold between November 1, 2022 and April 30, 2023. These new I Bonds will have a fixed rate of 0.4% for life, plus a variable rate that adjusts with inflation every six months. The variable rate in the first six months will be 6.48%. When the fixed rate and the variable rate are combined, the composite rate for these new I Bonds is 6.89% in the first six months.

I Bonds for the Short Term

All existing I Bonds bought between May 2020 and October 2022 will continue to have a 0% fixed rate for life. They will earn a 6.48% variable rate for six months after they finish earning 9.62% for six months. The 6.48% rate is still higher than anything you can find in a safe investment.

If you maxed out on I Bonds in 2022, you’ll have an opportunity to buy I Bonds again in January 2023. All the reasons to buy I Bonds in 2022 are still valid in 2023. I Bonds remain a flexible principal-guaranteed investment. They’re great for short-term money that you might spend or reinvest into something else at any time after holding for one year.

TIPS for the Long Term

However, as long-term holdings, I Bonds now face strong competition from TIPS, which are another type of inflation-protected government bond (see Better Inflation Protection with TIPS After Maxing Out I Bonds for more background on TIPS). The Treasury Department raised the fixed rate on I Bonds because the yield on TIPS is much higher now.

As I’m writing this in November 2022, the yield on TIPS is about 1.6% for all maturities whereas the fixed rate on I Bonds is only 0.4%. In other words, TIPS pay 1.6% above inflation while I Bonds pay 0.4% above inflation. TIPS win over a longer holding period.

I Bonds Advantages

There are still valid reasons for continuing to buy I Bonds in 2023 and keeping the existing I Bonds despite their low fixed rates:

1. There is a limit on how much new I Bonds you can buy each year. If you don’t buy them, you won’t accumulate as much in these flexible inflation-protected investments.

2. I Bonds are guaranteed never to lose value.

3. The existing I Bonds already accrued some interest. Cashing them out will trigger paying federal income tax on the accrued interest. I Bonds are exempt from state and local taxes.

4. Cashing out I Bonds before five years will forfeit interest earned in the last three months.

5. I Bonds are tax-deferred. If your tax rate is high now and it will be lower when you retire, holding on to them until you retire will arbitrage the difference in tax rates.

These factors in favor of buying more I Bonds in 2023 and holding on to the existing 0%-fixed-rate I Bonds are all true. Still, there has to be a point when it’s better to switch to TIPS. If 1.6% real yield versus 0.4% fixed rate doesn’t do it, what if the gap grows bigger?

Quantify the Difference

We need to quantify the advantages of buying more and holding on to the low-rate I Bonds. Then we will see whether the advantages overcome the yield difference. I created a spreadsheet for comparing two scenarios:

A) Hold on to an existing I Bond. Defer tax to the future when the tax rate is potentially lower.

B) Pay any tax and penalty now. Invest the proceeds in TIPS in a taxable account. Pay tax on interest every year.

The spreadsheet is interactive. Assumptions are in blue. Please feel free to change those to numbers applicable to you. The other cells are calculated. Please don’t overwrite those.

You get the current value and the composite interest rate of your I Bond from the Savings Bond Calculator. If the bond hasn’t been held for five years, the value displayed by the Savings Bond Calculator already reflects the 3-month interest penalty.

In the scenario shown, I have an I Bond bought in May 2021 with a 0% fixed rate. It’s still subject to the early withdrawal penalty. In Scenario A, I would hold it for another 10 years. The average inflation in the next 10 years is assumed to be 3%. Finally, suppose I pay a higher tax rate in the next 10 years than the tax rate afterward.

Under these assumptions, I’m still better off switching to TIPS and just paying taxes every year at a higher tax rate. If my tax rates are more or less equal between now and the future, it will be even better to switch to TIPS because there isn’t much tax rate arbitrage. If I have room for TIPS in an IRA, it will be better still.

The result may be different under a different set of assumptions. So play with the spreadsheet with your own assumptions and different scenarios and see how it goes for you.

When to Cash Out 0% I Bonds

The early withdrawal penalty on I Bonds is the interest earned in the last three months. If you decide to cash out and switch to TIPS, you may want to wait until your I Bonds finish earning the 9.62% rate plus another three months for the early withdrawal penalty. If you find the 6.48% rate attractive, you may want to wait until you fully pocket the 6.48% rate as well.

When your I Bonds fully capture the 9.62% rate or the 6.48% rate depends on when the I Bonds were issued. I made this table as a handy reference:

Issue Month 3 months after 9.62% 3 months after 6.48%
January or July 4/1/2023 10/1/2023
February or August 5/1/2023 11/1/2023
March or September 6/1/2023 12/1/2023
April or October 7/1/2023 1/1/2024
May or November 2/1/2023 8/1/2023
June or December 3/1/2023 9/1/2023

Because I already have enough for short-term flexible spending (“emergency fund” type of usage), here’s my plan for 2023:

1. Check the Daily Treasury Par Real Yield Curve Rates (use the second heading on the webpage). If TIPS yields are still high in January 2023, skip buying I Bonds and buy TIPS for the long term.

2. Check again on the dates in the table above. If TIPS yields are still high at that time and the I Bonds with a 0% fixed rate have been held for at least one year, cash them out to buy TIPS.

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