Have you wanted to earn interest on your cash that was both safe and protected against inflation? Buying Treasury Inflation Protected Securities (TIPS) allows you to achieve both of those goals. It’s safe because it’s backed by the U.S. government and as the name explicitly states, it protects the holder of TIPS against inflation. Understanding TIPS helps you decide if you want these instruments in your portfolio as part of the bond mix. Even though TIPS protects you against inflation, you’ll still need to make a judgment call about the future before you purchase them.
TIPS are notes that individuals can buy directly from the U.S. government with no fees. The minimum purchase amount is $100. TIPS are technically notes and not bonds because bonds mature anywhere from 20 to 30 years whereas notes mature anywhere from two to 10 years. Nonetheless, the concept is the same:
you lend money to someone
you lend to them at a defined interest rate
you lend over a period of time
you get interest payments during this time
when the “time is up” you get your money back that you initially lent
What’s different with TIPS is how much money you get floats with the inflation rate in the U.S. Specifically, TIPS will use the Consumer Price Index (CPI), which comes out every month. The interest is paid every six months, and that’s when the inflation is calculated. Inflation is calculated on the principal (the original money you lent the government) and not on the interest rate itself, which is fixed when you purchase the TIPS. Here is an example:
You bought $1,000 worth of 5-year TIPS on April 2024
The interest rate at this auction was 2%
If there was zero inflation in the year leading up to April 2025, you would get:
$1,000 x 2% = $20
If there was 5% inflation in the year leading up to April 2025, you would get:
$1,050 x 2% = $21
So the upside is:
you get interest that’s safe
you get payments that adjust with inflation
you get tax-free treatment on the interest payments at the U.S. state and local level but not at the federal level
The downside is:
you have to pay taxes on any gain even before you receive your principal. In the above example you would have to pay taxes on that $50 yearly gain.
if inflation goes down during your TIPS holding, your interest payments will also go down. However, you will never get less than your original principal. In the above example, you’d never get less than $1,000 when the five years are up.
Should you buy TIPS? You have to make a judgment call whether inflation is going down and making a judgment call five to 10 years later is hard. You may also not like paying taxes on gains on the principal when the inflation does go up. One thing you can do is buy TIPS as part of your tax-deferred retirement account, like 401(k). That way, you pay taxes when you withdraw from that account.