I-Bonds boast tax advantages, but purchase limits damp appeal.
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By Christine Benz | 06-24-10 | 06:00 AM | Email Article

Although inflation was a hot topic just a year ago, these days it barely elicits a yawn. Consumer prices actually dropped a touch in the months of May and April, stoking newfound worries that deflation could be a greater threat than inflation.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Yet retirees and preretirees who don't have pensions but do have a large share of their portfolios in fixed-rate assets ignore inflation at their peril. Although Social Security includes an annual inflation adjustment, and pensions usually do, too, payouts from fixed-income investments are just that--fixed. So when there are increasing prices on things that we all need to live--and historically consumer goods prices have increased at a rate of roughly 3% per year--the standard of living for someone on a fixed income is apt to go down.

So that's the reason behind adding inflation protection to your portfolio. I tackled how much to hold in inflation-protecting assets in a previous column, and the timing questions in this one.

Those articles focused mainly on Treasury Inflation-Protected Securities, or TIPS. But investors looking to add explicit inflation protection have another option: I-Bonds.

I-Bond Basics
I-Bonds are Treasury bonds that pay a fixed rate of interest as well as another layer of interest that varies with the current inflation rate, as measured by CPI. The inflation adjustment is made twice a year, in May and November. I-Bonds issued this past May yield of 1.74%, composed of a fixed rate of 0.20% and an inflation adjustment of 1.54%.

I-Bonds are available only to individuals--that's why there are no I-Bond funds--and they're available with face values as low as $25. I-Bonds reach their final maturity 30 years after issuance, but investors can cash them in 12 months after purchase. If you redeem an I-Bond within five years of buying it, however, you'll forfeit three months' worth of interest. You can buy I-Bonds either as paper securities or electronically.

I-Bonds don't pay you income while you own the bond. Rather, the interest accrues and gets paid out when you sell or the bond matures.

Pros: Because I-Bonds don't make regular interest payments, holders aren't on the hook for any taxes until they sell or the bond matures. So if you plan to buy and hold an I-Bond for many years, it's fine to do so within a taxable account--you won't owe taxes on the accrued interest until you no longer own the bond. When you do pocket income from I-Bonds after they mature or you sell, you'll owe federal tax but not state or local. And those who use I-Bond proceeds to pay for college expenses will be able to skirt federal tax, too, assuming they (and their expenses) meet certain criteria. Because I-Bonds already come with an element of tax deferral, you can't hold them inside an IRA.

Cons: Although I-Bond buyers could scoop up $30,000 in I-Bonds a few years ago, new I-Bond purchases are currently restricted to just $10,000 per year ($5,000 paper, $5,000 electronic) per Social Security number. That purchase limit is a major drawback for larger investors looking to build a meaningful bulwark against inflation.

And because I-Bonds don't make regular interest payments but instead pay you your income when you sell, they're not a good option for those looking to fund any part of their living expenses with the current interest from the bonds.

Securities mentioned in this article

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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