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Originally published March 22, 2010 at 11:58 AM | Page modified March 22, 2010 at 12:10 PM

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New way to use your tax refund to combat inflation

Uncle Sam wants you - to save more.

AP Personal Finance Writer

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CHICAGO —

Uncle Sam wants you - to save more.

A new option added to tax forms this year allows you to designate part or all of your federal income tax refund to purchase paper U.S. savings bonds known as I-bonds.

Consider it a well-meaning nudge from the government, which knows that many Americans are setting themselves up for trouble by not building adequate nest eggs for retirement.

I-bonds may not be for everyone, and experts may debate whether they are the best place for your investment to grow. But it's hard to criticize this new option - it's almost always a good idea to save more.

In this installment of "Your Money," we answer questions about the I-bond.

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Q: What exactly are I-bonds?

A: They are inflation-linked government savings bonds sold by the U.S. Treasury, formally called Series I savings bonds (the "I" is for inflation). They pay a fixed rate of interest as well as an adjustable component, which resets every May and November to reflect the change in the Consumer Price Index.

I-bonds earn interest for 30 years and are meant to be held for the long term. They cannot be redeemed in the first year after you buy them, and if you redeem them in less than five years you'll forfeit interest from the three most recent months.

They also are available either in paper or electronic form through the Treasury site http://www.treasurydirect.gov. But this is the first time you can have your refund diverted directly into savings bonds.

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Q: What is the current yield?

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A: The total return if you buy now is 3.36 percent. The fixed-rate component is 0.3 percent above inflation for any bond purchased in the current (until April 30) six-month period. That's what you will earn for that component as long as you hold the bond, even if inflation shoots higher.

The yield will next be adjusted on May 1.

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Q: How do you convert your refund into I-bonds?

A: If you prepare your own return, file Form 8888 ("Direct Deposit of Refund to More Than One Account"). Instead of listing an account number for direct deposit, enter "bonds."

The bonds must be bought in multiples of $50, up to a maximum of $5,000, with the remainder going into your bank account as in the past. If the refund happens to be an exact multiple of $50, simply enter the request for bond purchases on the tax return and skip the special form.

The I-bonds will be mailed to you.

If you don't do your own return, just tell your tax preparer you want to buy savings bonds with your refund.

You also can buy them directly at http://www.treasurydirect.gov. This has the advantage of letting you buy more - up to $5,000 electronically per calendar year per person in addition to $5,000 in paper bonds - and in more denominations.

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Q: Why are I-bonds worth considering?

A: Many investors love them because they earn interest and serve as a hedge against inflation. They also are government-guaranteed and tax-deferred until the bonds mature or you cash them out.

"If you think inflation's going to go up, they make a lot of sense," says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants.

The convenience of being able to save directly from your tax refund also makes them an easy way to set money aside for taxpayers who might not be in the habit of saving for retirement. If not for retirement, they also could be squirreled away for an emergency fund or for future major expenses, from college tuition to medical bills. I-bonds can be redeemed and used to pay for qualified educational expenses with no taxes owed on the accrued interest.

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Q: What are the disadvantages of I-bonds?

A: If this is money you could need in the near future, it's probably not a good idea since you can't redeem them for at least a year and to get your full return you'd need to hold it at least five years.

Also, the yield sounds hard to beat at the moment for a low-risk investment. But you're locking it in for the long haul, and when interest rates inevitably rise the payout will not hold up as well to other investment options.

"A margin of just 0.3 percent above inflation for something you have to hold at least five years isn't particularly attractive," says Greg McBride, senior financial analyst at Bankrate.com.

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Q: What is an alternative to buying I-bonds?

A: Treasury inflation-protected securities, or TIPS, also are issued by the government with future inflation in mind.

The returns are comparable to the I-bond over a five-year period. But McBride calls TIPS a much more compelling option than I-bonds if held for 10 years or longer because of better returns in an inflationary environment. They offer more inflation protection than the 0.3 percent you would currently get with an I-bond for the life of the bond, or up to 30 years.

By comparison, he notes, the after-inflation returns of TIPS trading now are 0.32 percent for five-year TIPS, 1.46 percent for 10-year TIPS and 2.09 percent for 30-year TIPS.

Even so, Ochsenschlager says that anything that encourages people to save more is a good option.

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If you have a question you want answered, e-mail it to yourmoney(at)ap.org.

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