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The Pros and Cons of I-bonds, an Inflation-Protected Bond

In times of high inflation, are inflation-protected bonds right for you?

December 9, 2022

This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment adviser before making investment decisions.

Inflation has been dominating news cycles lately. As the Consumer Price Index (CPI) rises, more families are having a harder time managing basic expenses. When everything from gasoline to a gallon of milk becomes more expensive, purchasing power decreases and your earnings don’t go as far.

This can also be true of money that you keep in your savings account. While putting extra money in a savings account helps you earn some interest, the interest rates on these accounts are typically much lower than the rate of inflation. So, even though money in a savings account is growing through monthly interest payments, your purchasing power is still decreasing.

Because of this, many people are looking for other places to put their money — including inflation-protected bonds, such as I-bonds. In this guide, we’ll help you understand what I-bonds are and whether these government bonds are right for you.

What are inflation-protected bonds?

Bonds are a type of investment that acts as a loan. A company or the government can raise money from investors by issuing bonds. The investor is then entitled to their initial balance plus interest when the bond matures. An inflation-protected bond is one where the interest rate or principal changes based on inflation fluctuations. 

The U.S. government issues a variety of bonds and Treasury securities through the U.S. Treasury, including Treasury bonds, series EE savings bonds and inflation-protected bonds. The two types of inflation-protected bonds are Series I savings bonds (I-bonds) and Treasury Inflation-Protected Securities (TIPS).

What are I-bonds?

Series I savings bonds are a type of inflation-protected bond made available through the U.S. government’s TreasuryDirect website. Because the government is the issuer, these bonds are considered low risk.

I-bonds are only available digitally unless you use your tax return to buy them (in which case you can buy paper I-bonds). Annually, the maximum you can purchase is $10,000 when buying digitally, and $5,000 when buying paper I-bonds, for a total of $15,000. 

I-bonds can earn interest for up to 30 years. You purchase it with an initial investment, or principal, that earns interest at the rate set by the U.S. Treasury. After six months, the interest earnings from the last six months are applied to your principal. This adjusted principal amount then serves as the “new” principal for the next six-month period.

I-bond interest rates are adjusted every six months as well. The total interest rate you receive is actually a combination of a flat, fixed rate plus an inflation-adjusted rate.

When the account reaches maturity or you cash it in, you’ll receive your original principal plus all the accrued interest. You’ll never lose money because the initial principal is treated as money you put in a standard savings account.

The benefits of I-bonds

High inflation means your money doesn’t go quite as far as it used to. For this reason, some people turn to inflation-protected bonds, like I-bonds. This is because I-bonds help protect your purchasing power, have a low initial investment requirement and are a relatively safe investment. Let’s look at each of these benefits.

Purchasing power protection

Because I-bonds are inflation-indexed, you can trust that your ever-increasing principal value will help you grow your finances in line with inflation. As the money in your account grows along with current economic factors, it’ll maintain its purchasing power.

In fact, when the Treasury first started offering I-bonds in 1998, it said, “I-bonds are designed to offer all Americans a way to save that protects the purchasing power of their investment while assuring them a real rate of return over and above inflation.”

Low initial investment requirement

You don’t need to make a significant initial investment to purchase I-bonds; TreasuryDirect allows you to purchase I-bonds with a $25 investment. So, even if you only have $100 to set aside for this type of savings, you can still get started.

A safe investment

The stock market can fluctuate significantly. During some periods, high growth can result in significant gains. But at other times, the money you invest will lose value based on the activity of the stocks and mutual funds you’ve invested in. 

For example, at the end of October 2022, the S&P 500 had a year-to-date return of -18.76 percent. That means if you’d put in $100 at the start of 2022, by October, it would only have been worth $81.24. The Dow Jones had also recorded a year-to-date return of -9.92 percent.

With an I-bond, you won’t lose any of your principal value; the final amount you receive won’t be less than your initial investment, even if deflation means that your interest payments slow down. For example, if you invested $10,000 in I-bonds, you won’t receive less than $10,000 when you cash out the bond.

Potential drawbacks of I-bonds

While I-bonds are a safe investment that can provide protection during periods of high inflation, they aren’t perfect. There are a few drawbacks to be aware of before you invest.

Potentially lower total returns than other options

When it comes to financial decisions, you want to consider opportunity cost. According to Investopedia, “opportunity cost is the forgone benefit that would’ve been derived from an option not chosen.” So while an I-bond will provide 6.89 percent growth for the next six months, your money might grow more through another financial or investment vehicle.

For example, let’s say you have $1,000 and you’re trying to decide what to do with it: put it in a high-yield savings account with a 2.50 percent interest rate, buy an I-bond with a 6.89 percent rate or invest via exchange-traded funds (ETFs), stocks or mutual funds. Based on past performance, the stock market has returned 10 percent on average.

You might look at each option and consider the opportunity cost of choosing one over the other. For example, you might look at the savings account vs. the I-bond and weigh how much growth you’d receive from one or the other, or how much your money will grow with the I-bond vs. how much it might grow in the stock market.

However, you’ll also want to consider the risks of each option. There’s a lot of volatility in the stock market, so future results aren’t guaranteed; you might even lose your money. Meanwhile, an I-bond’s rate could go down during times of deflation, lowering your growth potential.

This is why it’s a good idea to enlist the expertise of a financial adviser. They can consider various risks and opportunity costs to help you determine the right diversification and asset allocation for your money.

Less liquidity than a savings account

I-bonds aren’t necessarily a good fit for short-term savings that you may need to access at a moment’s notice. 

You don’t have to wait a full 30 years before you cash in your inflation-protected bond, but you do have to leave it untouched for at least 12 months. If you cash in your I-bonds before five years have passed, you’ll lose the last three months of interest earnings. So, if you want to cash in your account after 24 months, you’ll only receive 21 months’ worth of interest earnings, in addition to your original principal investment.

However, with a regular savings account, you can make withdrawals or transfers at any time. This makes it easier to access the money you need for expenses.


Tax concerns

While you don’t have to pay state or local income taxes on I-bond earnings, you do need to pay federal income tax on them. I-bonds are taxed at your income tax rate, not the capital gains tax rate. You may also have to pay estate or inheritance taxes on these earnings, when applicable.

You’re given the option to either report how much you earned from your account each year or report all of your earnings at once when your bond matures or when you cash it in. Reporting your earnings annually means you’d have to pay taxes on your account, even when you don’t yet have the cash in hand. On the other hand, waiting to pay until you cash in your I-bonds could mean a much larger tax bill that year.

Consult with a tax professional to determine when to report your I-bond earnings and how much you need to pay in taxes.

Making the right savings and investing choices

During times of high inflation, inflation-protected bonds can be a great way to protect your money from inflation risk. And unlike stock market investments, you don’t risk losing your original principal amount once your I-bond account matures. At the same time, changes to the market could mean that you’ll ultimately earn less than if you’d invested in stocks or mutual funds.

This means that while inflation-protected bonds are a low-risk choice, you might miss out on other growth opportunities.

Because of this, carefully evaluate both your own financial situation and the market as a whole when deciding how to invest. Consulting with a financial adviser can also help you make the right decision for your needs.

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