Rates on I bonds are expected to drop in November. Why they're still offering the best risk-free return

Published Fri, Oct 21 202212:25 PM EDT

For investors navigating this inflationary environment, there has been no better risk-free return than the Series I bond. The asset, backed by the U.S. government, has a variable rate based on inflation. Right now, that interest rate is a record 9.62% through Oct. 31. It's expected to fall to roughly 6.48% in November , although the rate will only be known once the government announces it. The asset also has a fixed rate, which is currently zero. While inflation is still high, the Federal Reserve is hiking rates in an effort to bring it down. Yet experts believe the I bond is still a great way to earn income for at least the next year. If you buy an I bond before Oct. 28, you will lock in the 9.62% interest rate for six months. After that, you'll earn the new interest rate for another six months. "In a year when every asset class is so unpleasant, this is something that people can do to feel like they have a bit of control and they are putting their money into an investment that will pay them a very clear and guaranteed interest rate," said certified financial planner Brenna McLoughlin, senior advisor at Wealthstream Advisors. What you do after that year depends on several factors, including future interest rates, the amount of money you have in I bonds and your tax situation. How to buy I bonds I bonds can only be bought on the government website, TreasuryDirect.com , which has been recently updated . That means keeping track of an account separate from your other investments. "Time is money," said CFP Carolyn McClanahan, founder of Life Planning Partners. You'll have to make sure you are checking interest rates and when they go down, you'll have to move the money out and into a diverse portfolio, she said. "Some people just don't want the hassle." You should also make sure that you have added beneficiaries to your TreasuryDirect account and that these individuals know how to track it. Without a beneficiary, accessing the bonds could prove difficult for any heirs in the event the bondholder dies or becomes incapacitated. How much you can buy You also have a limit to how much you can invest each year. Individuals with Social Security numbers, including children, are capped $10,000 annually. Therefore, a family of four can invest $40,000, with the minors' bonds in custodial accounts. You can also buy up to $5,000 in paper bonds through federal income tax returns. Trusts and businesses can each also purchase $10,000 in I bonds a year. However, legislation has been introduced in the Senate. Called the Savings Security Act of 2022 , it would raise the annual cap to $30,000 per person when the average of the annualized changes in the consumer price index for all urban consumers during any six-month period exceeds 3.5%. "Arbitrary purchasing caps on I Bonds … are shortchanging the public from better utilizing the program," Sen. Deb Fischer, R-Nebraska, said in a September statement announcing the bill. How to fit I bonds into your portfolio You could consider I bonds part of your savings, but it would not be the core part of your emergency fund because you have to hold onto it for at least 12 months. "Make sure you have a cash reserve first before you start looking at these," said Tyler Huck, a financial advisor for Atlanta-based oXYGen Financial. While the bond technically earns interest for 30 years, it's also not generally considered part of your longer-term fixed income bucket. When inflation goes down you likely won't be earning much, McLoughlin and McClanahan said. Therefore it sits somewhere in between emergency savings and a long-term investment. The key is keeping an eye on inflation. You lose three months of interest if you cash it in before five years, but it is still worth doing so if rates are going down, they said. At that point, you'll want to see where that money may earn more elsewhere. "In the short term, it's going to juice your portfolio," McClanahan said. "If you are going to need it in the next year or two, that is a great interest rate you can make." However, a diversified bond portfolio will likely provide the same results over the long term, she added. Another thing to think about is how much you are holding in I bonds, McLoughlin said. Any interest you make on I bonds is subject to federal income taxes, but not state or local levies. If you accumulate them over the years, are able to add more than the annual $10,000 or the cap gets raised, it could become a bigger holding and you may want to see if there is a smarter tax-free investment elsewhere. "Think about the after-tax yield and if it is a long-term holding, is it more appropriate to roll it into a municipal bond strategy?" McLoughlin said. Municipal bonds are generally free of federal taxes and potentially state and local levies as well. That makes them particularly attractive to high earners in high income tax states. Either way, when inflation comes down you'll want to consider your next move. "People can spend it. They can put it into their portfolio if they want to choose to take on more risk to get more return then they are getting from cash," McLoughlin said. If you are risk-averse, you could also simply move it to a savings account. "At some point it may be that bank accounts are offering more [interest] than an I bond and you have free liquidity there," Huck said. That could mean a money market or high-yield savings account, he said.