One needs to understand inflation before learning about inflation protected investments and bonds (i.e. Treasury Inflation Protected Securities or TIPS and Inflation Protected Bonds: I Savings bonds). Inflation is the rate at which the values and prices of goods and services rise. If prices rise, the buying power of the consumer decreases. In other words, when inflation rises and prices rise, the same dollar amount buys less goods. Inflation affects society as a whole. This is a problem for savers trying to accumulate funds for retirement and future consumption.
Anyone who needs to convert current income into savings for future expenses can be harmed by inflation. For example, if you save money on tuition 10 years in the future and your bank pays 3 percent interest, assume that the 3 percent interest rate would increase your initial funds by 3 percent per year at the end of 10 years. If inflation was 4 percent per year during this period, your money would buy less at the end of the savings period than when you started. Although you get a 3 percent return on your money, you subtract inflation from 4 percent a year and your actual purchasing power drops by about 1 percent (3 percent return minus 4 percent inflation rate = -1 percent).
Inflation protected investments were created by the United States government to offer savers investment products that protect savings from a decline in real value and purchasing power. There are two types of inflation protected investments:
- Treasury Inflation Protected Securities (TIPS) and
- Inflation Protected Government Bonds (adjusted for inflation)
By investing in these benign government products, clients are assured a return that keeps pace with the government's calculated inflation rate.
Treasury Inflation Protected Securities (or TIPS)
Treasury inflation protected securities are marketable securities that resemble a bond investment. This means that you can buy them or sell them to other investors before their final due date also known as maturity date. The due date is the specified date on which the buyer receives the full amount due (principal). The principal or face value of TIPS changes with inflation and deflation, calculated using the non-seasonally adjusted Consumer Price Index (CPI-U). For example, when inflation rises, the principal value of TIPS increases by the same amount. With rising inflation, you can be sure that the value of your TIPS bond will also increase in value.
There is a second part of the return on a TIPS investment. When buying, the TIPS have an interest rate that remains fixed for the entire useful life. This interest rate is paid every six months on the adjusted capital amount. For example, buy a five-year $ 1,000 TIPS bond with a 1 percent interest rate. When inflation rises, interest of 1 percent is paid semi-annually on the increased principal. In the event of deflation, the 1 percent interest is paid on the reduced amount of capital. When due, in this case five years, the TIPS owner will receive either the adjusted capital or the original capital if there is no inflation or deflation. It also protects the consumer from deflation as he never receives less than the original principal.
Federal tax is due on the semi-annual interest payments and inflation adjustments in the year in which they occur. Interest is subject to federal tax and is exempt from state tax.
How to buy TIPS: Denominations and Maturities
TIPS are sold in denominations from $ 100 to $ 5,000,000. Their maturities are 5, 10 and 30 years and they can be auctioned on the treasurydirect.gov website or at a bank or an investment broker. TIPS (previously issued) are also available on the secondary market. The secondary market means that investors buy and sell TIPs securities in a similar way to investors buying and selling stocks and bonds. In other words, TIPs can be held to maturity or sold on the secondary market at any time before maturity or due date.
Inflation Protected Bonds: I Savings bonds
Similar to TIPS, inflation protected bonds i.e. I-savings bonds are intended to be a savings product that protects consumers' money from loss caused by inflation. Although the purpose of I Bonds is the same as that of TIPS, the investment I bond is produced in a unique manner. I-bonds combine two interest rates, with a fixed return which is determined when the bonds are created. The second interest rate is calculated every six months and is based on changes in the non-seasonally adjusted consumer price index (CPI-U). The interest is calculated every six months and earned monthly. The published value of the bond does not show the interest of the past three months. Although the buyer, like TIPS holders, does not receive any semi-annual interest payments, the final repayment value includes all previous interest payments.
The value of I bonds changes every month when interest is calculated and applied to the principal. Unlike TIPS, ownership is neither transferable nor capable of trading on the secondary market. I bond can be redeemed at any time after 12 months on the treasurydirect.gov website or at a bank. If you redeem the I-bonds prior to five years, you lose the interest accrued over the past three months. The principal and all interest due will be paid upon redemption.
Taxes on I-Bonds are only due when they are redeemed. However, the consumer can choose to pay taxes annually. Interest is subject to federal tax and is exempt from state tax.
How to Buy Savings Bonds: Denominations and Terms
I savings bonds can be purchased electronically on the treasurydirect.gov website. They are offered in denominations of $ 50, 100, 200, 500, 1,000, and $ 5,000. The number of I-bonds that a person can buy each year is limited. Investors can purchase I-bonds up to $ 10,000 and up to $ 5,000 I-bonds annually with an additional tax refund.
Educational Considerations for I Savings Bonds
The Education Savings Bond program provides that interest on savings bonds is exempt from federal tax if the proceeds from savings bonds are used to pay for qualified higher education expenses at an eligible institution in the same year that the bonds are repaid.