Q: I am receiving some extra cash as a result of maturing CDs. I want to make a safe investment that is protected against future inflation. We do not need this money, and so I am interested to know what you think of purchasing I Bonds for our grandchildren. I have heard they can be tax free if used for college.

Sincerely,

Inflation Is A-Comin’

MONEY QUESTIONS by Matthew Illian, CFP^®

Dear Inflation Is A-Comin’,

I bonds offer a low-risk and cost-efficient avenue to protect purchasing power, but they have inherent limitations. Their yield comes from a combination of a fixed rate (currently 0%) and an inflation rate that adjusts semiannually based on the Consumer Price Index—All Urban Consumers (CPI-U) (currently 4.6%).

With the fixed rate at 0%, this means that current I bonds only offer an inflation adjustment, and many savvy statisticians point out that CPI-U underreports the true increases in food, fuel, health care, and other necessary goods and services. For a more powerful inflation hedge, look into mining companies that produce and sell commodities that will do a better job of keeping abreast of rising prices, although these investments are more complicated to gift.

Giving a gift that grows over time also means you are giving the gift of a financial education. Most of our clients give financial gifts to their grandchildren by setting up 529 plans to pay for college expenses. However, if you do not want to open an education-specific fund, I think I bonds are the next best solution. Children should be taught early about the complexities of investing and I Bonds are a relatively simple place to start.

Buying paper U.S. savings bonds from local banks will soon be history. As of January, 1, 2012, you will only be able to purchase up to $5,000 worth of I Bonds directly from the U.S. government at www.treasurydirect.gov.

You need to wait one year after purchase to redeem I bonds, but they are very liquid after that point. Publicly traded bonds are subject to interest rate risk when rates begin to lift off the floor from historically low rates but not U.S. savings bonds. After one year, you can always get your money back with interest. There is a three-month interest penalty in the first five years, which will not amount to much of a deterrent for those who need quick access to cash.

You will want to consider your options before you designate the owner. If you want your grandchildren to have the opportunity to use these funds tax-free for education, check the income limits and make their parents the owners of the I bonds. If you are the owner, or if your grandchildren are the owner, you will not optimize the tax savings for education. In this case, I recommend that you make your grandchild the beneficiary.

If the bond owner is married, he or she must file a joint return to receive a tax break. The income limits are adjusted each year, so you’ll want to make sure you have the current figures. See the latest version of IRS Form 8815 for the Modified Adjusted Gross Income (MAGI) limits in effect at the time you redeem your I bonds. In 2010, the full tax exclusion was available to couples with MAGI of up to $105,100, and a partial exclusion is available up to $135,100. For a single parent, the full break is available up to $70,600 and a partial break up to $85,100.

If you do buy these I Bonds online, TreasuryDirect® offers gift certificates that you can print off and give to the beneficiary of this gift. They may not understand the value of that piece of paper today, but they will one day.

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