Invest in: US Treasury Bonds
Risk: None
Return: Low to Mid
Allocation: 10%
I'm sure that most people have heard of savings bonds before. If you haven't then the most basic explanation is that a bond is a way to finance the US debt. You are loaning your money to the Federal Government to use. Most people still believe that you buy bonds for a set amount of money and in a number of years they double in value. While there is still a bond like that called Series E, the bonds that we are talking about investing in are a newer bond type called Series I. I Bonds are inflation indexed bonds that pay out a percentage much like a savings account.
The Rates
Series I bonds have two functions that make up their interest percentage. The first is a fixed number that is set when you buy the bond. The second is a inflation index that changes depending on the state of the economy. If inflation is up, the percentage raises. If inflation lowers so does the interest percentage. These rates are set by the Federal Government every April and November. Any bonds that you buy will adjust their rates every six months. This is important to remember because if you invest heavily in bonds before the rate changes they will not adjust to the new rate in April or November but will instead adjust to the new rate every six months from purchase. This allows you to possibly capture a higher interest rate for the first six months if the indication is that the inflation index will go down for the next period.
Some Things to Consider
Beyond the changing rate there are also some other important rules that apply to Savings Bonds. When you purchase a Savings Bond you cannot cash it in until you have held it for one year. This is important to remember and another reason why although the bonds will make more money, a Savings Account is still necessary for easy to access funds. Along with the one year holding period if you cash in a Savings Bond before you have held it for 5 years you will forfeit the first 3 months of interest payments. This isn't a huge loss just be aware if you are considering early withdraw. You must buy bonds in increments of $25 and they will stop gaining interest after 30 years.There is currently a $10,000 dollar per person per year limit on buying Series I Savings Bonds. At my level of investing and allocation that amount is far from what I will be putting into Bonds. Because you cannot use the interest gained from Bonds without cashing them out they only serve as a safe investment rather than the focus of the portfolio.
And most importantly the benefits
Now on to the rules that make Savings Bonds even more attractive. Savings Bonds are State Tax exempt. Depending on your State this may or may not make a large difference in how much you take home but not having to pay anything out in even low tax rates is a nice advantage. I Bonds compound their interest every 6 months so you won't be making interest only on your initial investment but will start accumulating interest from your interest. You pay taxes on your interest earnings when you withdraw the funds. Assuming you are using this for retirement then your income should be substantially lower when you withdraw the funds in retirement so you would (theoretically) be in a lower tax bracket and thus pay lower federal taxes on earnings. Lastly I Bonds can be Federally tax exempt if used for education however that isn't a goal of mine.
Risk - None. If the Federal Government defaults on its debt I doubt anyone will be retiring anyway.
Return - Low, currently 1.94% as of April 2014. Had you purchased I Bonds in the first part of 2000 your fixed portion would be 3.6% which would net you 5.4% right now which is rather good. Even with the current rate of 1.94% you are beating out Savings Accounts and CDs at today's market price.
Allocation - My allocation for I Bonds is 10% of my portfolio. Along with my Savings Account this gives me guaranteed funds should the Stock Market of housing prices take another dive.
Suggested - There is only one place to go for I Bonds and that is Treasury Direct at http://www.treasurydirect.gov/tdhome.htm . Here you can buy them over the Internet directly from the Government. No paper to keep track of.
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