TIPS are a type of security offered by the U.S. Treasury that provides protection against inflation. When you purchase a TIP, you will receive the interest payments semi-annually and you will at least receive your original principal amount at maturity, however unlike a regular Treasury bond, the interest and redemption amounts are tied to inflation rates.
How TIPS Works
The interest rate is the rate at the time of purchase and will remain fixed until maturity of the bond. The inflation-indexed feature of the interest rate, which is based on the Consumer Price Index (CPI), adjusts the accrued principal value of the bond upwards each year by the amount of inflation. Essentially, what happens is the principal amount of the bond adjusts for inflation because the interest rate is not applied to the par value of the bond, but rather to the inflation-adjusted principal value (there is a formula to determine what this figure is). Principal increases with inflation and decreases with deflation. The semi-annual interest payments that are paid out are based on the inflation-adjusted principal value of the bond at the time the interest is to be paid. If inflation occurs while you hold TIPS, each interest payment will be higher than the last. In the event of deflation, the interest payments will decrease.
At maturity, you will either receive the inflation-adjusted principal amount or the par value of bond, whichever is greater. If inflation has occurred, then you are going to receive more at maturity than what you paid for the bond. If there has been deflation, you are going to at least break even. The system is set up so that a purchaser never receives less than what was paid for the bond.
TIPS are issued in five-, 10- and 30-year terms. There is no minimum term of ownership.
Taxation of TIPS
Because TIPS are Treasury instruments, interest and growth in principal are exempt from state and local tax, but you will owe federal tax on the interest earned as well as on the increase on the principal value even though you will not receive the adjusted principal value until actual maturity of the bond. So, increases in principal are taxable in the year they occur, even if your TIPS has not matured. In this sense, TIPS are very much like zero-coupon bonds or STRIPS.
Henssler Financial Position
Because most maturities for TIPS are at least 10 years or greater (normally 30 years), they generally do not fit into our Ten Year Rule philosophy. Our philosophy states that any money you need within 10 years should be invested in fixed-income investments and any money not needed within the next 10 years should be invested into growth investments. We suggest only buying fixed- income investments for specific liquidity purposes over the next 10 years. We suggest Treasury bonds, notes, CDs, or municipal bonds (if your tax bracket warrants), depending on interest rates at the time of purchase. History has shown that for periods of 10 years or more, you would be better off being invested in the stock market. If you do not need the money within the next 10 years, then it should be invested in the market.
Remember that you spend cash, not income. What would happen if you purchase a TIP specifically for income purposes? This may be fine during times of increased inflation, but what would happen in a reverse situation? The income stream you have counted on could be reduced. Why take this chance when there are other safe and viable options? We suggest laddering out Treasury bonds, CDs, etc., to cover your annual spending needs not already covered by other sources of income. As these fixed-income instruments mature each year, you would spend the principal. You would not have to worry about inflation or what interest rates are doing because funds to cover your needs would already be locked in.
It is also not advantageous tax-wise to buy TIPS for those who have liquidity needs outside of tax-deferred accounts. We believe you would be better off in a regular Treasury bond.
There are instances that may warrant the purchase of TIPS (if nothing more than just to get the inflation protection) rather than another fixed instrument:
- A specific need further out than 10 years;
- Investors who are buying fixed investments for a longer time horizon than we recommend;
- Investors who are too nervous about being invested in the market and who do not have a need for the money.
The Bottom Line
Based on individual situations, goals, needs, and your tax situation, you should compare an after-tax return on several fixed-income securities and always check with your tax adviser before purchasing. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].