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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35345  
Subject: Re: I Bond Tax issues Date: 3/24/2006 1:18 PM
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One issue that nobody has mentioned yet is the effect of non-reportability of I-Bond income on deductions. I-Bond interest is not reportable, and not taxed, until you cash in the I-Bond (which can be up to 30 years).

If you retire early, you may have to buy private health insurance (this is our situation). Medical expenses (including health insurance plus any medical expenses) are only deductible, if they exceed 7% of income.

I-Bond income is not reported. This lowers the threshold of deductibility of medical expenses.

Others have spoken about buying I-Bonds in IRAs. My understanding is that the only entities that can buy I-Bonds are individuals and trusts, not IRAs. The I-Bond is a way of turning non-IRA money into the equivalent of IRA money.

As Loki said, TIPS are yielding more than I-Bonds, over inflation. There are a few subtle differences between these two investments.

TIPS interest, plus the inflation-adjusted increase in the principal of the TIPS, are reported and taxed, each year. That is, you pay tax on an increase in principal, before the TIPS is cashed in. This tax has to be paid from a separate source. Once the TIPS matures (or you sell it), you will receive the increase in the principal, in hand...however, this increase must be paid for all along -- possibly from the interest that is periodically paid from the TIPS. I believe that this increase is treated as a capital gain.

If you need the cash from the TIPS, you can sell it, on the secondary market. However, if interest rates have risen, you will get less for the TIPS than you paid for it. However, the principal of I-Bonds is guraranteed: you always get paid the par value, when you cash an I-Bond, even if interest rates have gone up. (That guarantee of principal is also true of CDs.) If you buy a TIPS, you must either decide to hold to maturity, or take the chance that interest rates will be stable/decline.

The question is: given the prevailing interest rates, the prevailing risk premia, and your particular circumstances, which fixed-income investments are better for you?

You might want to look at this historical chart, of nominal and real interest rates. Context is always useful.
http://www.martincapital.com/chart-pgs/CH_mmnry.HTM

Wendy
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