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Series I bonds: Your protection against inflation

Many people seeking shelter from the decline in fixed-income investment returns are running for the cover of savings bonds.

One bond in particular -- the Series I bond -- is garnering a lot of attention. The government began issuing I bonds in September 1998. It's an inflation-indexed, shining light in this long, dark economic tailspin.

CDs are at their lowest interest rates in almost 20 years. They offer no inflation protection and are subject to state and local taxes. That makes I bonds look pretty good.

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What's an I bond?
I bonds earn interest for up to 30 years and are sold in eight denominations, $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000.

Originally you had to hold I bonds for six months before you were allowed to cash out. The government extended the minimum holding period to one year effective with bonds issued as of Feb.1, 2003. However, if you cash them out in less than five years, you'll forfeit three months' interest.

What makes the I bond so popular is it's the only inflation-indexed savings bond. You won't lose principal or the fixed interest rate.

The current interest on I bonds is 4.8 percent. That's comprised of two separate rates: a 1.20 percent fixed-rate of return and 3.58 percent variable semiannual inflation rate.

The fixed rate is just that, fixed for the life of your bond. The Treasury Department adjusts the inflation rate every six months -- in May and November.

Return can change
However, both the fixed and inflation rate can be changed with each new issue of bonds every six months.

"The I bonds have been selling quite well and become more popular as people learn about them," says Christina Graff of the Treasury Department's Philadelphia Savings Bonds marketing office.

"A lot of people tell us they're happy with the inflation protection, and it's a little simpler to understand than the EE savings bond in terms of what you're holding. I bonds are purchased at face value vs. EEs, which are bought for half the face value and eventually mature to full value."

Daniel Pederson, author of "Savings Bonds: When to Hold, When to Fold and Everything In-Between," says he expects I bonds to continue outselling EE bonds, the Treasury's other savings bond, for at least the short term.

Considering I bonds?
Pederson considers the I bond one of the better alternatives to low-rate CDs. At this writing, the average yield on a 5-year CD according to Bankrate's CD rates is 4.42 percent. Another benefit is I bonds are exempt from state and local taxes, where the CD or money market is subject to state and local taxes.

Certified financial planner Barry Vosler of DeWitt, Iowa, says as long as inflation doesn't drop too drastically, I bonds are a good bet.

"Take a snapshot of what else is available in the market. It has a higher interest rate than Treasury obligations and most CDs. It's very competitive right now."

I bonds weren't the darling of the conservative investment world when they were first issued, according to Pederson.

"Inflation was abnormally low -- it was at something like 1.2 percent. It was like selling hot chocolate in the summer, but it quickly turned to winter when inflation returned to normal levels of about 2.5 to 3 percent. It's become a very attractive product."

Interest, tax implications
I bonds increase in value monthly, and interest is compounded semiannually. The interest accrues and is paid at maturity. Federal tax on the interest is deferred until the bond is cashed, which gives you, the investor, control over when to pay the tax.

Investors may purchase up to $30,000 worth of I bonds per year per Social Security number. In a family that wishes to have significant resources in conservative investments, the husband and wife could each buy $30,000 worth of I bonds. They could then purchase an additional $30,000 for each of their children simply by putting the child's name first on the bond and listing the husband or wife as co-owner.

Be aware that in a co-ownership situation, either party can cash the I bond without the knowledge or approval of the other. So, if your intention is to hold the bond as an investment but little Susie thinks it should pay for her first car, you may want to have a talk.

I bonds can be used to pay for college tuition and fees. Up to 100 percent of the interest in I bonds is exempt from federal taxes if you meet certain eligibility requirements.

I bonds can be bought and redeemed at just about any financial institution. They may also be available through your employer's payroll savings plan, or you can download order forms and mail them in.

-- Updated: May 6, 2005




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