Kent Smetters: I Bonds protect against inflation and are backed by US Treasury
I Bonds are probably the safest "base layer" of retirement investment possible, Smetters says
Editor’s Note: Kent Smetters, a former deputy assistant secretary for the US Treasury, is a professor at the University of Pennsylvania’s Wharton School, a faculty research fellow at the National Bureau of Economic Research and the faculty director of the Penn Wharton Budget Model. The opinions expressed in this commentary are his.
Here’s an important tip for year-end financial planning: Getting started now will allow you to secure a safe source of savings as well as tax benefits for the current year. But you might want to hurry because the clock is ticking if you want to invest before the end of the calendar year.
Imagine an investment backed by the full faith and credit of the US Treasury. Its nominal interest rate is about the same as a high-yield CD, but this rate automatically increases with higher inflation. Moreover, interest accumulated on this investment is only taxed at the end of the holding period, not during, and so taxes don’t create a big drag on the investment’s compounding value over time.
This investment actually exists. They are called I Bonds. But the private sector has no incentive to tell you about them. You buy I Bonds directly from the federal government’s Treasury Direct with no fees or commissions. You simply need to first establish a free account.
In contrast, the private market pushes variable annuities as a “guaranteed” investment alternative. But variable annuities are typically loaded with fees, don’t offer true inflation protection and are not backed by the federal government. Variable annuities are also often packaged with marketing gimmicks, including exaggerated claims about tax benefits (you are often better off with a simple taxable brokerage account) and counting the repayment of your principal investment as a “return” on your investment.
Here’s how I Bonds work. A single person can buy up to $10,000 per calendar year, or $20,000 for a married couple. If you have kids with their own Social Security numbers, you can usually buy I Bonds for them as well. You buy your bonds using after-tax dollars, somewhat like a Roth IRA. All I Bonds mature (stop earning interest) 30 years after purchase. However, assuming you have held the bonds for just one year, you forgo just three months of interest if you cash them in earlier. The bonds don’t pay coupons along the way; instead, after the bond expires, you get your money back, plus the additional return. As inflation varies over time, the government adjusts your return to maintain the bond’s purchasing power.
Unlike a Roth IRA, there are no income limits on who can purchase an I Bond. Moreover, you don’t pay a 10% early withdrawal penalty if you redeem them before age 59.5. However, unlike a Roth IRA, you do eventually pay federal income taxes (but no state and local income taxes) on the additional return, unless you use them for educational expenses (although you’re usually better off using a 529 plan for educational purposes). But this federal income tax is not imputed during the compounding of your returns, just at the end. That saves you money.
Why add I Bonds to your portfolio? Because they are probably the safest “base layer” of retirement investment possible (although you can use them for nonretirement goals as well). I Bonds are even safer than Social Security. Contrary to what many people think, your projected Social Security benefit is not backed by the full faith and credit of the US government. Social Security represents the policy of the US Congress, and it is subject to change.
In fact, the Penn Wharton Budget Model projects that the Social Security trust fund will be exhausted in just 14 years, about three years faster than the official estimates. When that happens, if Congress fails to take other action, Social Security benefits will be reduced across the board – even on retirees – under current law by about 25%, growing to over 30% over time.
And, why should you care so much about inflation? It seems reasonably low right now. But times are changing. Under current policy, US federal debt will soon reach World War II levels and not turn back. That usually means more inflation, as governments pay back debtors by printing more money.
If you want to learn more about I Bonds and requirements, see Treasury Direct. Moreover, my friend Zvi Bodie, a distinguished finance professor at Boston University, and his co-author, Rachelle Taqqu, have written a great book about it called “Risk Less and Prosper.”
But as I mentioned earlier, you should get started now. Setting up an account at Treasury Direct is not instant because they must send you some verification by mail. You can buy $10,000 per Social Security number this calendar year and then another $10,000 as soon as the clock strikes midnight on New Year’s Eve, for calendar year 2017.
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However, if you only feel comfortable buying financial products steeped with heavy commissions, then still do yourself the favor of buying $10,000 in I Bonds this year. Then feel free to send me $1,000 in unmarked, non-sequentially numbered $100 bills. I am at least as deserving as that broker trying to sell you a loaded variable annuity. (Just kidding about sending me the money!)