What to Know About Treasury Inflation-Protected Securities (TIPS)
What Is Regulation D in Banking?
Short vs. Long-Term CD Rates: What to Choose
What Is the Federal Reserve?What to Know About Treasury Inflation-Protected Securities (TIPS)
Treasury inflation-protected securities (TIPS) are U.S. Treasury bonds that can help protect you from inflation by adjusting in value as prices change. This can support keeping the purchasing power of your investment intact.
Here’s how TIPS work, along with their pros and cons.
What are Treasury inflation-protected securities (TIPS)?
TIPS are U.S. government bonds designed to protect against inflation.
Price inflation can eat away at the value of your bonds over time because you can’t buy as much with the same amount of money. To guard against this, the principal value of your TIPS rises with inflation.
However, the opposite can also happen. If consumer prices decline over time – also called deflation – your TIPS can decrease in value, though never below what you paid for them.
How TIPS work
Unlike other Treasury bonds with a fixed dollar value, or principal, the principal of TIPS can change as the Consumer Price Index (CPI) — a common measure of inflation — rises or falls during the bond’s term. The U.S. Treasury issues TIPS in terms of 5, 10 or 30 years.
If the principal is higher than the original amount at the end of the term (maturity), you’ll receive the higher amount.
If the principal is lower than the original amount at maturity, you’re guaranteed to get at least the original amount back.
You can hold TIPs until their maturity date or sell them before they mature. While you own TIPS, you’ll receive interest payments every six months.
The base interest rate is determined when you buy the TIPS and remains fixed for the entire term.
TIPS pros and cons
PROS
- Inflation protection: Your TIPS principal adjusts with inflation. If inflation rises, so does your principal.
- Safety: TIPS are backed by the full faith and credit of the U.S. government.
- Principal preservation: Even if your principal goes down during the term because of deflation, you’ll still get at least the original amount back at maturity.
CONS
- Lower rates than other bonds: TIPS may offer lower yields than other Treasury bonds.
- Deflation risk: The principal value of your TIPS could fall if deflation occurs, leading to lower interest payments.
- Phantom income: If your principal value goes up because of inflation, income taxes are due on the increase the year it occurs, even if you haven’t received the money yet. This is known as the “phantom income” tax.
Are TIPS a good investment?
It depends on your financial goals and the state of the economy.
TIPS are generally considered a safe investment because they carry little to no default risk. You’re also unlikely to lose your original principal.
However, your principal can decrease during periods of deflation, which may reduce your interest payments. If there’s a risk of falling consumer prices, you may want to consider another investment.
TIPS vs. Series I bonds
Both TIPS and Series I bonds are U.S. Treasury bonds that offer inflation protection. However, there are a few important differences to understand:
- TIPS are more liquid — they can be bought and sold on the market, while Series I bonds cannot.
- The minimum purchase amount for TIPS is $100, and you must buy them in increments of $100. You can purchase Series I bonds for as little as $25.
- TIPS have a fixed interest rate, while Series I bonds have a combination of a fixed rate and an inflation rate.
- You’ll receive interest payments on TIPS every six months, while Series I bonds don’t pay interest until you redeem them.
There are also some smaller differences, as explained on the government’s TreasuryDirect website.
Are TIPS taxable?
TIPS earnings are exempt from state and local income taxes.
You’ll pay federal income tax on interest income you earn from TIPS in the year it’s received. And as noted, you’ll also pay taxes on any principal growth in the year it occurs.
You’ll receive two tax forms each year:
- 1099-INT, showing the interest paid out to you
- 1099-OID, showing the increase or decrease in the principal value
How to buy TIPS
You can buy TIPS through TreasuryDirect, a financial institution or a broker.
TIPS purchased directly from the Treasury are sold in single-price auctions, meaning everyone pays the same price. However, prices can vary when you buy them through financial institutions or brokers.
Frequently asked questions
Are Treasury inflation-protected securities safe?
Treasury inflation-protected securities are considered safe investments because they are backed by the U.S. government and help protect your investment against losing value from rising prices.
Can Treasury inflation-protected securities lose money?
The principal value of TIPS can go up or down during the term because of inflation or deflation. But if you hold your TIPS until maturity, you’re guaranteed to get at least your principal back.
What happens if you sell TIPS before maturity?
If you need to sell TIPS before the end of their term, you could either gain or lose money, depending on market conditions. For example, if new TIPS are being issued at a higher interest rate than what you originally got, you may need to sell your TIPS at a discount to attract a buyer.
