Last Updated May 7, 2011 10:10 PM EDT
I found this gem when looking at a favorite site for CDs, DepositAccounts.com , and noticed the best rate wasn't actually a CD. I spoke with this site's founder, Ken Tumin, to get more information on this opportunity.
What is an I Bond?
I Bonds are issued by the US Treasury and pay a variable interest rate based on inflation (CPI). They are long-term products but, similar to the Ally Bank easy early withdrawal penalty, they can be cashed in one year after purchase with a three month penalty. While they pay interest for 30 years, they can be cashed in after five years with no penalty.
I bonds have two advantages over CDs.
1. Interest isn't taxable until the bond is redeemed.
2. Interest is state tax-exempt because interest is paid by the US Treasury.
The US Treasury calculates the interest rate in arrears every six months. The recent six month inflation rate (October 2010 to March 2011) was 4.60 percent annualized. This means that the I Bond will pay out this 4.60 percent annualized rate from May to November 2011.
We won't know the rate after November but, even if it turns out to be zero, you will still earn about 2.5% annually if you cash it out in one year, paying the 3 month penalty, which also works out to be zero in this case.
Now if inflation clocks in only a two percent annual rate over the next six months, you do have to pay a penalty, though the net rate goes up to 3.05% annually. Higher inflation means higher rates. It may turn out that the last thing you want to do is cash in your I Bond.
Important Steps in Opening Your I Bond
Timing is everything. Because the I Bond pays a full month's interest in the month it's purchased, the above annualized rates are assuming the bond is purchased at the end May. Thus, you get 12 months interest even though you only have the funds deposited for a tad more than 11 months.
To buy the I Bond, go to Treasury Direct and open an account. You can have the funds taken directly from your bank account. Each individual is limited to $5,000 of bonds per year at Treasury Direct, but you can buy another $5,000 by going to your bank.
Tumin notes, as with any CD, investors should also make sure the US Treasury hasn't change the early withdrawal penalty. Though they can't do it retroactively for any previously purchased, make sure the current penalty is three months and the minimum holding period is still one year.
For more details on this strategy and how I Bonds work, check out Ken Tumin's outstanding blog on how iBond rates top short-term CD rates.
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