Beat Inflation With I Bonds

Hey, want to sock away some money and earn 3.83% interest over the next 12 months? That’s better than the rate on online savings accounts (about 1%) and 1-year CDs (1.2% at best). It’s even better than the rate on 5-year CDs.

Furthermore, unlike savings accounts and CDs, the financial instrument I’m talking about is guaranteed to keep up with inflation, and you can hold it for up to 30 years. You’ll never pay state or local income tax on it, and don’t have to pay federal tax until you cash it in.

This is real, risk-free, and not a scam; there are almost no catches. You can and should do it today, because that guaranteed 3.83% rate expires at the end of October.

I Bonds Revisited

I’m talking about Series I US Savings Bonds–“I-bonds” for short. (No, they’re not an Apple product.) At a time when complaining about low interest rates is our national pastime, few people know about these bonds. The Treasury has no budget for advertising savings bonds, so you have to hear about them from fans like me. They’re the financial equivalent of an unsigned indie rock band, except that savings bonds have been around forever and will never be featured in Pitchfork.

“It’s a product designed for Main Street, not Wall Street and the banking industry,” writes Chris Farrell in Kiplinger’s. That’s exactly it: only individuals can buy savings bonds. If I-bonds were a club, Goldman Sachs wouldn’t make it past the velvet rope.

Buying savings bonds has a reputation for being complicated, so I’m going to tell you exactly how and why to do it. I’m buying some today; you should, too.

How They Work

I-bonds are like certificates of deposit. You put money in, it grows in value, and at some point you cash it out and spend the money.

You can’t cash out an I-bond until its first birthday, so don’t put in any money you might need in the next year. If you cash it out in less than five years, you pay a small penalty: you give up the most recent three months of interest payments.

Unlike a CD, an I-bond has a variable interest rate tied to the rate of inflation. If you buy an I-bond before October 31, it will pay 4.6% APY for six months and then 3.06% APY for the following six months (3.83% is the average of the two rates). After that, the interest rate will change again: it changes every six months and could go higher or lower, but it will never be less than the inflation rate.

To put it simply: if you buy a $1,000 I-bond (which has a picture of Einstein on it) today, it will be worth $1038.30 in a year. Again, that’s by far the best you can do in a risk-free investment today.

Each person can buy up to $10,000 worth of I-bonds this year. The limit drops to $5000 starting in 2012.

How to Buy

The easiest way to buy I-bonds is to mail-order them, Sears Roebuck style. (Yes, my jokes are as venerable as savings bonds themselves.)

Just fill out this form, print it, and mail it with a check. This will probably be the only time in your life you write a check to the Federal Reserve Bank of Minneapolis. They’ll mail you the bonds in a couple of weeks. As long as your check arrives by October 31, you’ll get the current, delicious interest rates.

If you can only afford to put $5000 or less ($10,000 for a couple) in I-bonds right now, stop reading, submit your order, and relax with a beverage knowing you’ve joined a secret society of expert savers.

Because here’s where it gets complicated. You can buy up to $5000 in paper bonds (that’s what you’ll get via mail order) and another $5000 in electronic bonds. To buy electronic bonds you have to sign up for an account with TreasuryDirect, the government’s direct bond sales web site. It’s similar to signing up for online banking, but the security measures are Iron Curtain-inspired.

Starting next year, you won’t be able to buy paper bonds any more, so if you want to keep buying I-bonds, you’ll have to sign up for TreasuryDirect, in any case.

The Take-Home

I-bonds are the perfect savings tool for short- to medium-term savings goals: down payment, vacation, college tuition (if you use I-bonds to pay for college, you can cash them in tax-free). The fact that you can’t cash them in for a year protects you from impulse buys. They grow tax-deferred. They never lose purchasing power due to inflation.

Nobody regrets buying I-bonds. If you have money sitting around earning 1% or less, pick some up today.

Welcome to the club. Let’s work on a secret handshake.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.