If you have established a habit of saving and have built up a decent amount of cash, you may start to wonder if there is a way to hold your savings somewhere that won’t leave you exposed to inflation. There are those who advise you to invest that money, but that’s not really a good idea. This is the money you intend to use when the unexpected happens. This means that it can’t be locked up in an investment. It has to be accessible immediately. Wouldn’t it be nice if there was an investment that would allow your emergency savings to grow with inflation, but still allow you access that money during an emergency? It takes a little planning and patience, but there is a way.
Beneficial Features of I Bonds
If you are a “United States person,” you can put your emergency savings in I Bonds. United States Series I Savings Bonds have some unique features that make them especially attractive for this purpose:
I Bond interest is linked to inflation
They can be purchased online
They can be purchased in small or larger amounts
They can be sold anytime after a one year period
They keep earning interest for up to 30 years
Interest is state-tax free
Interest is federal tax deferred
This means that if you start moving a small portion of your emergency savings into I Bonds each year, you could eventually have it all moved over. Once your entire reserve is in I Bonds, and a year has passed since the final purchase, you can take that money out if you ever have an emergency. If you don’t it will earn interested at whatever rate necessary to keep up with inflation.
How to Do It
Here’s a scenario that you might adapt to your own situation. Let’s say that you have a $3000 emergency fund sitting in a money market account at the bank.
Then, I would suggest that you save an extra $300. You would now have $3,300 in emergency savings. That’s $300 too much. Take that extra $300 and buy an I Bond.
After a year passes, that bond will be available as emergency savings only it is now probably worth more than $300 because of the inflation adjustments. Now you are $300 too high in your emergency savings fund again. This time take $300 out of your money market account and buy an I bond. Wait for another year. Now you have over $600 in I bonds and $2,700 in your money market account. Keep moving $300 each year until all of your emergency savings is in I Bonds.
The Tax Advantages
One of the great things about doing this is that, unlike a money market account, you are not taxed at the local level, and all of your federal taxes are deferred. You only pay taxes on a savings bond when you cash it out. This is especially attractive when you find yourself in an emergency.
If your emergency happens to be the loss of a job and you are forced to cash some I Bonds, you will probably be doing it at a lower tax rate. This may also true if you end up needing it while you are retired. It’s actually better from a tax point-of-view to take money out of I Bonds when you have less income.
If you have a lot of emergency savings, make sure that you don’t attempt to buy more I bonds than you are allowed to buy. Each person with a Social Security Number is allowed to buy up to $10,000 in I Bonds per year. If there are two of you, you can both buy $10,000 as long as you both have an account set up. You can learn more about these bonds in my article: I Just Want to Save My Money.
Another thing to understand, is that if you are forced to sell an I Bond between the second and fifth year after your purchase, you will lose two months of interest when you sell it. Since you were already losing this money in your money market account, it’s not a big price to pay for protection. You still get all of your original principal back. After 5 years, all of the interest is yours, no matter when you cash out.
The Next Step
Since you have already proven that you have the discipline to save, you might as well take the next step and start the process of inflation protecting your emergency savings.
Bonds are one of the easiest and most common ways to save money for the long term. There’s a good chance you already own one. If you have a certificate of deposit at your bank or your credit union, you own a kind of a bond. CD’s are quite a bit different than other kinds of bonds, but they have many things in common.
I mentioned back in my introduction to TIPS that bonds are actually a type of loan. CD’s are loans that you make to the bank. If you ever wondered how to turn the tables on a bank and get them to pay you interest, that’s how. If you have had a CD before, you know that it has an end date. That’s how bonds work. They “mature.” When they do, you get your money back.
Because bonds have a due date, they are great for eliminating timing risk. Bonds come with a promise to return your money on a specific day. If you intend to go on a big vacation in two years, you can get a two year CD at the bank and earn higher interest than you would in a regular savings or checking account. When the CD matures, you get your money back and all the interest right when you need it.
You can imagine what might happen if you put that money in a mutual fund for two years. If you happen to have planned your vacation during the next stock market crash, you probably would have to change your plans. It might be ok to miss your vacation, but putting off your retirement because you took that risk would probably be a bigger deal.
Certificates of Deposit and Inflation
Taking out a two year CD might not be that bad. At the time I write this, CD rates are still quite a bit lower than the rate of inflation. When that is true, you end up paying the bank to hold and protect your money. That’s not always a bad idea. Putting all that money in your house might be worse, but it sure would be nice to be able to keep up with inflation don’t you think?
I Bonds vs. CD’s
You might consider I Bonds for a two year holding time or more. You can’t take your money out for the first year, so if you need the money sooner than that, it wouldn’t be a good idea. If you need the money in less than five years, it would still be a pretty good idea to put your money in an I Bond because it protects your purchasing power at the cost of losing three months of interest. It’s still better than most bank CDs at the time that I write this. After five years of waiting, you can take the money out any time. If you have more than 30 years to wait, you will have to sell your bond in thirty years and get a new one. You can find out more about I Bonds in another article.
The advantage of using an I Bond over a CD is that you are more certain to keep up with inflation. There are CD’s that allow you to “step up” your interest rate if the interest rates go up at some point. The problem with that is that interest rates and inflation are not really linked. The will of the government is in between. Governments occasionally force interest rates lower as a way to “fix” the economy. As a result, CD’s have proven to not be a very precise way to protect your money’s purchasing power.
Using a Bond Ladder
You may have seen an article or heard someone at your bank talk about putting some money in a CD ladder. This arrangement helps you take advantage of changes in interest rates over time. It’s another way to attempt to deal with inflation issues as well.
The idea is that you split up your money, and buy CD’s or bonds with different maturity dates. For instance you might buy one for six months, another for one year and another for two years. The idea being that every six months you would have a CD coming due. When it does, it allows you choose whether you need to use some of the money or put it back into another CD. It also allows you to take advantage of changes in the interest rates as they go up.
When you are trying to save your money for later, bond ladders have much different purpose. When you are using inflation protected bonds like I Bonds or TIPS you don’t really have to worry about the interest rates. Remember that taking advantage of rising interest rates is the kind of thing we do with the part of our money set aside for opportunity investing. When we are dealing with the preservation side, what we concern ourselves with is timing. We just need to ask ourselves: When do I need this money? In this case, we would use a ladder to put the right amount of money in the right place in the future to meet our needs.
Here’s an example. Suppose you need your money in 15 years. It may require that you take out a ten year TIPS, and after 10 years you need to remember to buy another 5 year TIPS when it matures. You can think of your needs like buckets of money. Let’s say that you have one bucket for each year during your retirement. You need a ladder of bonds that reach to each bucket in order to fill them with the right amount of money so that you meet all of your needs.
Beware of Bond Mutual Funds
Bond mutual funds don’t have a maturity date. Shorter duration funds may be safer than stock funds, but they are definitely more risky than just owning the bonds. That’s because the fund share prices change every day based on market forces, not inflation. I plan to explain that more in an article about mutual funds.
A Smart Way to Plan
Bonds are a great way to plan because they are based on time commitments. Not everything in life can be planned, but for things that need to be, it really makes sense to use investments that have commitments built into them so that you can be sure to have money when you need it.
Trying to decide what to do with the money you have can be stressful. There are plenty of people willing to “help” you invest your money, but they rarely agree on how. Just leaving it the bank doesn’t seem right, but neither does losing it all in the market. I have found that dividing my money into two parts reduces the stress and gives me confidence.
Protection vs. Opportunity
There are two very different points-of-view when it comes to investing money. It’s possible to look at money as something to protect for some point in the future. It is also possible to look at it as an opportunity for gain. Both perspectives have benefits, but they require that we invest in different ways.
When we look at money from a protection point of view, we want to make sure that we don’t lose it. Our concern is not about future gains, but about having something at a specific time.
When we look at money from an opportunity point of view, we are willing to wait in order to get a big gain. We’re hoping to use money in order to get significantly more, but we can’t really control the timing of it.
These two points of view, are at odds with one another. Like the old saying goes, you can’t have your cake and eat it too. We can’t protect something and risk it at the same time. When we choose opportunity, we also choose to risk not having our money at a specific point in time.
Many of the professionals in the financial world are more focused on opportunity than they are on protection. It’s good to keep that in mind when you seek help. If your intention is to protect, you probably won’t need professional help. With a little education, you should do just fine on your own.
Insurance vs. Investments
Those who intend to preserve their money are better off thinking about it like they would insurance. That’s because when you preserve, you are saving what you’ve already earned. You’re just making sure that it’s there for you when you need it. A preservation mentality is helpful when you are saving for specific things. Those things might include maintaining or buying a car. Other things include buying a house, paying for college or for paying for retirement. Preservation is good for those things that you already know that you will probably need.
When you want to use your money to take advantage of growth opportunities, insurance doesn’t really make sense. That’s because you’ve accepted the risk that your money won’t necessarily be there at a specific point in time.
Promise vs. Potential
When we make a decision about where we put our money, we need to decide whether we care more about having a promise that our money will be available, or that we have the potential to gain when opportunity arises.
These kinds of financial arrangements are at odds with each other but they both have their place. If there was no potential for gain, there wouldn’t be a way to have something to preserve. If there was no place to save your money, how could you keep what you have gained for a time that you need it?
Determine Your Timing Related Risk Capacity
When I say “timing related risk,” I mean the kind of risk you expose yourself to by not having money when you need to use it. Considering your timing related risk capacity is a good way to decide whether you should preserve or speculate.
source: nattanan23 (Pixabay)
If you don’t have any savings at all, then you are at risk whenever something doesn’t go right. You really don’t have any capacity for timing risk. If you have no extra money and your car’s transmission fails, you would immediately be in financial trouble. It’s important to have emergency savings and not having it definitely qualifies a timing related risk.
There are other timing related risks you may have. Retirement is an important one. You can calculate the amount of time that remains before you plan to retire and the amount of money you might need for the rest of your life from that point. These projections expose a risk. If your retirement money isn’t there when you need it, you will probably suffer. Other things have timing related risk too, like buying a house, paying for college or paying for family vacations.
When we think about risk, we need to consider what we would feel like if our money wasn’t there when we need it. If the money you are thinking about isn’t going to be needed for a particular time in the future, then opportunity investing is probably a good idea for you. If you know what the money is intended for, then preservation investing would probably be a better idea.
A Helpful Separation
I have found it helpful to separate my money into two distinct parts. One is the part I intend to preserve as savings. That part includes my emergency savings, the part of my retirement savings that would pay for my basic retirement needs and any other amount of money that I would rather preserve than take risks with. These may include funds I intend to use as an inheritance or a donation.
The other part is for investments that I believe will eventually be profitable. For these investments, I accept that I don’t know when they will be profitable and I am willing wait.
By taking your savings and setting it aside as something you intend to preserve, you don’t have to worry about how much money it makes. As long as it keeps up with inflation, it will still be there for you. The rest you can use to do some investing. That’s the part you may want to have an investment professional help you with. If things don’t go quite as well you expected them to go, you can rest assured that your savings is still intact.
So, you are at the point where you have decided to stay out of the market and all you really want to do is save what you have for later. The problem is, you haven’t found a way to save money for longer than a year or so, without feeling the effects of inflation. A simple look at the inflation rates reveal that you would have to get an interest rate of somewhere around 2% just to break even! With 5 year CD rates at 1.5%, you realize that you would be paying the bank half a percent to keep your money from you! If you were an irresponsible spender, that might make sense, but you are serious about saving. Now, am I the only one who thinks this is crazy? Why are more people not upset about this?
Running Toward Risk
One reason might be that people have been placated by the possibility that they could make money using the stock market. It’s hard for me to believe that this was not the intent of denying us the right to save our money. I believe it is dishonest for any government to act like money is money if it can’t be saved for more than a few months. It would also be pretty hypocritical for a government to complain about the number of people without savings, if they haven’t even provided a way to save this so-called money. Well, I’m happy to inform you that they actually have provided a way to save. There must be a few godly people in the government because they gave us a way to save money that can actually avoid much of the exposure to inflation. In the United States, there are actually two ways. They aren’t perfect, but they do appear to be a step in a good direction. This information is so little known, and so important, that I really wanted to share it.
The Old Way
I’m going to assume that you are familiar with how a savings account accrues interest. It’s important that you also understand how CDs or Certificates of Deposit work at the bank too. A typical CD is a special account in which you give the bank your money for a dedicated amount of time with the promise from them to pay you interest. If you take your money out early, there is a penalty. The interest is calculated on the amount of money you initially put into the account, plus any interest accrued. Now if that interest rate is less than the rate of inflation, you are actually losing money. That’s because what you can actually buy with the money has become less over time, while at the same time, the interest didn’t increase fast enough to give you the same purchasing power your money had when you earned it. So what did the United States Government do to help us in this situation?
The New Way
In 1997 the United States Treasury provided a new way of saving by issuing something called: “I Bonds. ” In order to understand what those are, you kind of need to understand what a normal “bond” is. Stocks and bonds are really different even though they are often spoken of together. When you “buy” a bond, you are actually loaning your money to someone. Pretty confusing right? It sounds like you are purchasing something when, in reality, you are loaning someone else your money! Well, no matter what it seems like, that’s what it is. When you buy a bond, you become the bank. You can loan money to companies by buying corporate bonds. You can also loan money to a government by buying government bonds. That’s one way that United States Treasury finances their needs and they allow individuals or institutions to buy bonds. One institution that does this is, … surprise…. your bank. In fact, those CDs you get are often backed by government bonds. I tell you this to help you understand that that these I Bonds are not really a new risk to you. You are accessing the same United States Treasury only in a different way. Let’s look at how a typical bond earns money for you.
A good old-fashioned bond used to be printed on paper, kind of like a dollar bill. On the face of this bill, it had a value, like $100. If you were to buy this bond at its face value you would loan the government $100 and they would give you this bill. In those days, part of your loan agreement was that every six months or so, the government would pay you by sending you a coupon in the mail for all the interest they owed you on that money so far. You could then go cash the coupon and use the money. That was your interest for allowing the government to use your $100. Another thing about your bill is that it would have a term associated with it that was recorded in a book somewhere. That’s the amount of time you agreed to allow the government to use your $100. When time is up, you can cash in your bill to get your $100 back. As long as they are using your $100, they promise to keep sending you your interest as coupons in the mail. Well, it’s pretty obvious that computers were bound to change this process a bit.
Buying Treasury Bonds Today
Now days, we use the same terms, but the paper is almost gone. You still can buy a bond, but the coupon never gets sent to you, it just accumulates in an account. In fact, the Treasury is willing to compound the interest now just like a CD. Not only that, you can go to the Treasury’s web site and open an account online, just like using online banking. Anyone with a Social Security Number is eligible. Their website even has a clever name:
Yes, you have your very own online bank account waiting for you, but wait, there’s more. Let’s go back to talking about I Bonds. I Bonds, or more accurately Series I Savings Bonds, are what the Treasury calls “Inflation Adjusted Bonds”. That’s right. They’re bonds whose interest is tied to inflation. That means that when inflation goes up, the interest rate on these bonds go up too. Part of the interest calculation is connected to an index that follows the cost of goods in the United States called the CPI-U. The CPI-U is a good topic for another article. It’s good to know, for now, that your interest rate will go up when inflation goes up. It’s also important to understand that what goes up, must also come down. If inflation goes down (yes that would be deflation) the rate goes down, but the Treasury decided that they would not allow your bonds to ever go below your original amount. That means you could actually make money in a deflationary time as well. If you want to buy an I Bond, I have step-by-step instructions available at this website.
The Tax Problem
Now let’s say that you are convinced and you’re ready to put some of your savings into one of these I Bonds. First, let’s talk about the down side. I Bonds, unfortunately, are not protected from taxation by the IRS. The United States Tax Code, for some reason, doesn’t recognize the fact that you already earned this money once. Evidently, our congress believed that simply recovering your money’s lost value to inflation is a taxable event and that we owe money for that. This means that you aren’t completely protected from inflation. You will have to treat your interest on an I Bond as “income” and report it. That’s the bad news. This same bad news spans all investments including your bank account. That’s not much comfort, but there are two tax advantages that you also need to consider as well.
First, we are allowed to defer reporting our interest to the IRS. You can choose to not report your interest until you need to use the money. The reason that this is significant is that you can wait to use the money for a rainy day, such as, a year when you don’t have much income. For many of us, that will probably be during retirement. At that time, you may not even be taxed, depending on what other income you have. The other advantage is that these bonds are not taxable by state or local governments, like your bank account is. So, even though taxes make things less than perfect when trying to shelter yourself from inflation, these I Bonds are one of the best things we have.
If you are interested in learning more about the effects of taxes on our inflation-protected savings, make sure to check out my post: Inflation Protection and Taxes.
Some Important Details
Now for some important details about I Bonds: You can buy an I Bond for $25 or more at Treasury Direct, but you can’t buy more than $10,000 in any given year. For many of us, that’s not an issue, but there are some who would like to save more than that. Well, there is another trick… You can use your tax return to buy about $5000 more and guess what, you will get the paper certificates! They are pretty cool, I have to admit. There are more pictures of them at Treasury Direct.
Also, I Bonds are a long-term investment. They act kind of like a CD in that there are restrictions about when you can take the money out. You can’t cash them in for the first full year. Also, you are penalized if you cash out before a 5 year term, but the penalty is not very bad. You would have to give up the previous three months of interest, but that’s it. Since you probably want to save anyway so that’s not a big deal. The good thing is that you can keep your money in this bond for 30 years! Yes you read that right. Anywhere from 5 to 30 years, the government is willing to keep growing your interest rate with inflation and allow you cash out any time. After 30 years the interest stops so it’s a good idea to cash it in and get a new one so you keep earning interest.