Are Treasury Inflation Protected Securities a Good Investment?
Written by
Karen Doyle
Edited by
Maria Concepcion
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Inflation makes everything more expensive. When inflation is up, things like groceries, clothing, cars, and homes cost more. The money you earn and save has less purchasing power, because you’re spending more on the same things.
What’s a consumer to do? One way to reduce the adverse effects of inflation on your wallet is by investing in Treasury Inflation Protected Securities, or TIPS.
Here’s what you need to know.
What Are TIPS?
Treasury Inflation Protected Securities, abbreviated TIPS, are debt instruments issued by the U.S. Treasury. They are similar to other treasury bonds. They pay a fixed interest rate on a semi-annual basis. You can purchase TIPS with maturity dates from 5 to 30 years. During that time, you get the semi-annual interest payments and the principal back at maturity.
How Do TIPS Protect Against Inflation?
The U.S. Treasury adjusts the par value of TIPS each year, based on inflation as measured by the Consumer Price Index, or CPI. Other treasury bonds have a fixed par value, which can be eroded by inflation over time.
This means that the interest payments are also adjusted for inflation each year. The interest rate remains constant, but the rate is applied to the higher par value each year, resulting in a higher interest payment.
Taxation of TIPS
Like other treasury bonds, TIPS are subject to federal income taxes but are exempt from state and local taxes. However, adjusting the par value of TIPS represents a unique tax scenario. When the par value is increased due to an inflation adjustment, the gain is reportable income in the year of the increase. Investors don’t receive the higher par value until the bond matures. This means you’ll be taxed on the increase in par value before you get it back at maturity, so it’s best to plan ahead for this tax consequence.
TIPS are low-risk investments that act as an inflation hedge, making them a good choice for risk-averse investors looking for income protected against inflation.
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