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Inflation Protection: TIPS and I-Bonds
Posted By Miranda Marquit On 06/15/2011 @ 12:09 pm In Investing | 7 Comments
Even with talk of possible default if a budget agreement isn’t reached by August 2, many investors still believe that U.S. Treasuries are among the safest securities in the world. However, the yield on investments  that are generally considered “safe” is usually quite low — sometimes it doesn’t even keep pace with inflation, resulting in a loss, in terms of real returns.
If you are interested in preserving capital, by at least keeping pace with inflation, there are some Treasury bonds that you can consider. These are TIPS and I-Bonds. There are differences between the two, and it helps to understand the differences when making a decision about whether or not to invest in these types of bonds.
TIPS are marketable, which means that they can be bought and sold on the secondary market. You can purchase TIPS through Treasury Direct in increments of $100 up to $5 million when bought non-competitively. It is also possible to purchase TIPS via competitive bidding, with a limit of up to 35% of the offering amount. TreasuryDirect offers TIPS, as does Legacy Treasury Direct, and you can get them through banks and brokers. You can get different maturities of TIPS, except you can’t get 30-year TIPS through Legacy Treasury Direct.
TIPS are indexed to inflation. The principal of your investment changes to reflect what is happening with the Consumer Price Index, while the interest rate remains fixed at what it was during the time of purchase. You receive interest payments semiannually; the interest is figured on the adjusted principal. You should realize, though, that you have to pay federal income taxes on the interest earnings, as well as on adjustments to your principal that result in an increase, in the year you receive them. Earnings from TIPS, though, are exempt from state and local income taxes.
The other inflation protected security offered by the U.S. Treasury is the I-bond. I-bonds, unlike TIPS, cannot be sold on the secondary market. And, while TIPS are available only in maturities of five, 10 and 30 years, I-bonds earn interest for up to 30 years, with rules regarding how you can redeem them. You can redeem I-bonds any time after 12 months if you are willing to pay a three-months interest penalty. After five years, though, there is no penalty when you redeem I-bonds.
You can purchase I-bonds via Treasury Direct in electronic form with a minimum purchase of $25, in amount, to the penny. Paper I-bonds are issued in denominations of $50, $75, $100, $200, $500, $1,000 and $5,000. You can get paper I-bonds at most financial institutions. There is a $5,000 limit for each year, per Social Security number. The rate is based on the semiannual inflation rate (CPI-U) every six months in May and November. A combination of the fixed rate, set when you purchased the bond, and the variable inflation rate, makes up your interest.
Rather than paying you semiannually, interest accrues over the life of the I-bond, and you receive payment when you redeem the bond. I-bonds only earn interest up to 30 years. The interest is subject to federal taxes, but you don’t have to report it until you redeem the I-bond — or it reaches its 30 year maturity. Earnings are exempt from state and local taxes.
No that you know a little bit about these two investments, you can decide which is likely to work best for you, as well as whether or not you want to investing in inflation protected Treasury bonds  at all.
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