Even though the current interest rates on Series I Savings Bonds aren’t much higher than other alternatives, these I-Bonds do have some unique characteristics that can keep them attractive.
Along with TIPS (Treasury Inflation-Protected Securities), these are the only investments you can make that are explicitly tied to a measure of U.S. inflation. (Some foreign-countries also have inflation-linked bonds.) Interest rates don’t always move perfectly with inflation, so having such protection can be helpful.
Exempt From State and Local Income Taxes
The interest from I-Bonds are exempt from state and/or local income taxes. Of course, this is only an advantage if you are subject to such taxes.
You can use to either report your interest earned on an annual basis (like a bank CD), or have the interest reporting deferred until maturity or redemption. This can be especially advantageous if you are in a relatively high tax bracket now, but sometime in the future you believe you will have at least one year where you will have lower taxable income (possibly on purpose) and thus can redeem at a lower tax rate (perhps even zero). I-Bonds keep earning interest for up to 30 years.
Educational Tax Exclusion
If you meet several requirements, you can even avoid federal income taxes completely when paying qualified higher education expenses at an eligible institution. More information at this TreasuryDirect page.
Series EE and I US Savings Bonds issued after December 31, 1989 may be redeemed tax-free in order to contribute the proceeds to a section 529 plan or Coverdell Education Savings Account. (To take advantage of this, file IRS Form 8815 to claim an exclusion for the interest after rolling the proceeds of these US Savings Bonds into a section 529 college savings plan or Coverdell Education Savings account. Write “529 College Savings Plan” or “Coverdell Education Savings Account” in the answer to 1(b), where it asks for the name of the educational institution. The specific citation in the tax code for this guidance is IRC Section 135(c)((2)(C).)
One of the restrictions that concerns me is that there is an income phase-out. In 2010, full phase-out occurs at a modified adjusted gross income of $135,100 for married filing jointly filers and $85,000 for single filers.