Tax refunds are a hotly debated topic. Many investors like them as a forced savings plan. Others recognize that your tax refund is an interest-free loan to the government. If you get a big tax refund, that means that the government has kept your money for the year and paid you zero interest!
As of Feb. 8, the IRS had processed 26.9 million individual tax returns and calculated the average refund at $1,949, a decline from last years $2,135 average refund for the same period.
Had you invested that money in a high yield savings account or CD last year and earned 2.25% interest, you would have earned roughly $50. Not a fortune, but enough for a nice dinner out or a small shopping trip to the mall.
Yet, the best way to invest your tax refund might come as a surprise.
Invest Your Tax Refund in Series I Savings Bonds
I Bonds, issued by the U.S. Government are an underappreciated asset class. Not only are they among the safest investments, these inflation-protected savings vehicles are also free from state and local taxes.
I Bonds are so coveted that the government only allows individuals to purchase up to $10,000 worth in a calendar year … except, if you purchase them with your tax refund. You’re entitled to buy an additional $5,000 with your tax refund each year, in addition to the initial $10,000.
You won’t hear of I bonds from your financial advisor because they are offered commission free.
Why Invest in I Bonds?
For diversification, investors need fixed, bond investments as well as higher-yielding stocks in their investment portfolios. As inflation increases, investors need their cash to keep up. If inflation rises to 3% and your cash account pays 2%, you’re losing 1% purchasing power.
Series I Savings Bonds solve the problem of rising inflation stealing your cash purchasing power.
Purchased directly from TreasuryDirect.gov I bonds can be bought in multiple denominations from $25 to $10,000 for an electronic bond. Paper I bonds can be purchased in $50, $100, $200, $500 and $1,000 denominations. I bonds can even be purchased through your employer’s payroll deduction plan.
The I Bonds interest payments are a combination of a fixed interest rate, determined at purchase and a variable inflation adjusted interest rate that changes twice per year. The variable inflation rate is based on changes in the nonseasonally adjusted Consumer Price Index for all Urban Consumer (CPI-U).
The current composite interest rate for Ibonds issued from November 1, 2018 through April 30, 2019 was 2.83%. This rate includes the fixed rate of 0.50%, that continues for the life of the bond and the variable semiannual inflation rate of 1.16%. Your bond interest rate changes dependent upon the month the bond is purchased.
Although the interest is earned monthly and compounded semiannually, both interest and principal are paid when the bond is redeemed.
I bonds earn interest for 30 years, unless you cash them in earlier. You’re required to own the bonds for at least one year, and if they’re redeemed before five years, you forfeit the previous three months of interest.
I Bond Bonus Benefits
In addition to the inflation protection benefit and safety, there are other reasons to invest in I bonds.
Investors can redeem I bonds to pay for qualified higher education expenses for an eligible institution, tax-free. That means the interest payments are excluded from state and local taxes as well as federal taxation. This makes I bonds an ideal savings vehicle, for qualified investors to pay college expenses coming due within the next few years.
I bonds can also be given as gifts, complete with a gift certificate for the recipient.
Easier Ways to Invest in I Bonds and Inflation Protected Securities
Although opening a TreasuryDirect.gov account is easy, some investors prefer the simplicity of investing in ETFS or mutual funds.
Inflation-protected bond funds also include another government bond product, TIPs or Treasury Inflation-Protected Securities. These are marketable bonds whose principal adjusts along with changes in the Consumer Price index. The fixed interest rate is paid on the adjusted principal value of the bonds. TIPs and I bonds have the same goal, protecting your capital from loss of principal due to inflation. While TIPS can also be purchased on the TreasuryDirect.gov website, they are popular holdings within inflation-protected funds.
Inflation-protected bond funds are another investment route for your tax refund. The Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) has a year-to-date return of 1.86% as of April 24, 2019 and a low 0.1% expense ratio. For a longer-duration inflation-protected bond fund, the FlexShares iBoxx 5-Year Target Duration TIPs Index Fund (NYSEARCA:TDTF) has a year-to-date return of 2.96% and a 0.20% expense ratio. Even digital investment advisors such as the Ellevest robo-advisor see the merit in inflation protected investments and offer Schwab’s US TIPS bond fund (NYSEARCA:SCHP) in their investment mix.
To preserve your capital, inflation-protected fixed income investments are a great place for your tax refund.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she does own both I bonds and an inflation protected ETF.