People saving for retirement are very conscious of the impact inflation can have on their retirement savings – or at least they should be. Thirty years from now, because of inflation, $1 million of today’s dollars might only be equal to $400,000. The effect is that you’re able to buy less with the same amount of money. Investors looking for a way to beat inflation might consider investing in TIPS.
Treasury Inflated Protected Securities or TIPS are a government-backed securities that adjust for inflation based on the Consumer Price Index or CPI. The U.S. Bureau of Labor Statistics defines the CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” Simply put, the CPI measures changes in the cost of living. TIPS adjust interest payments based on those changes.
How TIPS Work
TIPS can be purchased in maturities of 5, 10, or 20 years. The securities have a fixed interest rate, but the payout fluctuates with inflation. What actually happens is that the principle amount on these fixed rate bonds adjusts up and down with inflation and deflation. While the principle value on TIPS can fall from their inflated value, they won’t fall below the original investment amount as long as you hold until maturity.
At maturity, the U.S. Treasury pays either the original or the adjusted principle, whichever is greater. The good thing is that if the principle has deflated below your original investment, you still get at least your original investment back. However, if you purchased TIPS on the secondary market, you may not receive the full principle back at maturity.
Buy Direct or Invest in a TIPS Fund
You can purchase treasury inflated protected securities directly or invest in a fund that buys TIPS. When you invest in the fund, you might have to pay commission and management fees that aren’t present with direct purchases, but you’d get the advantage of sharing in the ownership of TIPS at varying maturities and some that are only available on the secondary market. Another
benefit if investing in TIPS funds it that you can automatically reinvest earnings, something you can’t do when you purchase TIPS direct. Since TIPS funds don’t have a maturity date, when you cash out, you do so at current market prices. TIPS are only sold in electronic form, so you won’t have a physical document that represents your investment.
TIPS are auctioned off at certain times during the year depending on the maturity of the TIPS. For example, 5-year TIPS are auctioned in April, August, and December. Interest rates are determined at the auction. You can buy TIPS only in increments of $100 and the minimum purchase is $100. At the auction, you (or your broker) can make a noncompetitive bid where you accept the TIPS yield that’s determined at the auction. Or, you can make a competitive bid where you state the yield you’d like. Only brokers can make a competitive bid and that may not be accepted.
Interest and Taxation
Interest payments are typically made monthly, quarterly, or semi-annually depending on whether you’ve invested in the TIPS directly or you’ve indirectly invested in TIPS by putting money in a fund that buys TIPS. Income from TIPS is subject to federal tax, but not state and local tax. Even principle growth is subject to taxation in the year of the growth even though you wouldn’t actually see the growth until maturity. Being taxed on money you haven’t received yet is one of the biggest disadvantages of TIPS. Many investors prefer to hold their treasury inflated protected securities in a retirement account which lets them defer taxes until retirement.