Here's What Happens When You Don't Hold I Bonds Long Enough

One benefit of putting your money into bonds, as opposed to loading up a brokerage account with stocks, is that they tend to be less volatile. They're a good investment option for people who are very risk-averse, or who are in or approaching retirement and want more stability in their portfolios.

Now, there are different types of bonds you can invest in, from corporate bonds (those issued by different companies) to municipal bonds (those issued by different cities, states, and localities). But you may be tempted to put your money into I bonds.

I bonds are government-backed bonds whose interest rate is pegged to inflation. During periods when inflation is high, I bonds can be a good bet, because you might manage to score a high rate of interest on your money while taking on minimal risk.

As an example, right now, I bonds are paying 4.3% interest through Oct. 31, 2023. And while that's comparable to what some savings accounts are paying in interest, savings accounts rates are not guaranteed.

Your bank might give you 4.25% on your money today only for you to see that rate drop to 3.75% in a few months. With I bonds, you're guaranteed 4.3% through late October, at which point the rate on your bonds will readjust based on inflation levels.

If you're going to purchase I bonds, however, you should know that they come with pretty specific rules. And it's important to familiarize yourself with them before locking your money away.

Beware the early cash-out penalty

There are different benefits to owning I bonds. In addition to snagging a competitive interest rate on your money, earnings from I bonds are exempt from local and state taxes. And federal income taxes can be deferred until you redeem your bonds.

However, you should know that you're required to hold I bonds for at least a full year before cashing them out. And if you cash out your I bonds before having held them for five years, you'll be penalized to the tune of any interest you earned during the three months prior.

That's why it's really important to make sure I bonds are a good investment for you before committing to them. And also, it's important to have access to other money you can use in an emergency so you're not forced to cash out I bonds early at a penalty.

Will I bonds make sense once inflation levels drop?

They may or may not. As mentioned above, the interest rate on I bonds will reset on Nov. 1. Once that rate is made public, you'll need to decide if I bonds make sense for you to buy from scratch.

Remember, too, that even if you buy your bonds by the end of October and lock in a 4.3% interest rate, that rate will renew in November. It's not like you're locking in that rate for the duration of your bonds. So that's something you'll need to consider, because there may be other types of bonds that make more sense for you to buy if you're looking to invest within that asset class.