The ABCs of Tips and I Bonds

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The ABCs of TIPS and I Bonds

Quick guide to how they work and how they can help hedge inflation

As inflation soars to levels not seen in four decades, Series I U.S. Savings Bonds and Treasury Inflation-Protected Securities (TIPS) are suddenly in high demand. Net sales of I bonds, for example, grew from a modest $10.6 million in June 2020 to nearly $5 billion almost two years later, according to the Bureau of the Fiscal Service.

I bonds and TIPS share some features.

You can purchase them directly from the Treasury Department. Both are backed by the full faith and credit of the U.S. government. And the interest income from them rises and falls with inflation, as measured by the Consumer Price Index (CPI). But each manages inflation risk differently.

Here is what you should know about these two inflation fighters.

I Bond Basics

I bonds pay interest based on a composite rate. It’s made up of a fixed rate for the 30-year life of the bond plus a rate that changes every six months (in May and November) depending on inflation.

Currently, bonds purchased from May 2022 through October 2022 have a fixed rate of 0%. But because of high inflation, I bonds also pay interest at an annualized rate of 9.62% for the first six months you own the bond.

The interest is added to your principal, allowing for compounding or earning interest on your interest. You receive the interest and principal when you cash in the bond.

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As Inflation Soars, So Have I Bond Sales

Source: U.S. Bureau of the Fiscal Service

How to Buy Them

You can purchase up to $10,000 of electronic I bonds each year directly from the government through an online account at TreasuryDirect.gov. The minimum investment is $25.

Want more? You can also direct the IRS to apply some or all of your tax refund to buy up to an extra $5,000 in I bonds―for a total of $15,000 for the year―by submitting Form 8888 with your federal return. These additional bonds, sold in denominations of $50, $100, $200, $500, $1,000 or $5,000, are paper bonds that will be mailed to you.

When to Hold ’Em

I bonds continue to earn interest for 30 years, although you don’t have to hold the bonds that long. You can cash them in as early as one year after purchase. However, if you redeem bonds within the first five years, you’ll forfeit the last three months’ worth of interest.

You can redeem electronic I bonds through TreasuryDirect.gov. You can cash in paper I bonds at some banks or by sending them to Treasury Retail Securities Services (www.frbservices.org).

How They’re Taxed

You’ll owe federal income tax on the interest you earn on I bonds, but not state or local taxes. You can pay taxes annually on the interest you earn each year or, like most people, put off paying the tax bill until you redeem the bonds.

Lower your tax bill.

You might be able to avoid federal taxes on some or all of the interest income on your I bonds if you use the proceeds to pay for qualified college expenses for yourself, a spouse or dependent. To qualify, you must have been at least age 24 when the bonds were issued, and your income must fall within certain limits.

Tips on TIPS

TIPS are more complicated. They are available in 5-, 10- or 30-year maturities. They pay out interest twice a year at a fixed rate, but the amount you receive can fluctuate from one period to the next. That’s because your principal―rather than the interest rate―is regularly adjusted for inflation.

So, when the CPI rises, your principal is adjusted upward, and your interest payment increases. But when the inflation index falls, your principal is adjusted downward, and you earn less interest.

In a prolonged period of falling prices–or deflation―it’s possible that your principal could drop below your original investment. But if you hold TIPS until maturity, you will receive the adjusted or original principal, whichever is greater.

How to Buy Them

The Treasury sells newly issued TIPS at auction, in which the price and interest rate are set. You can participate in these auctions by signing up for a TreasuryDirect.gov taxable account. Many banks or broker-dealers, including Fidelity Investments, also provide investors with access to the auctions. The minimum investment is $100 per auction; the maximum is $5 million.

Keep it simple.

An easy way to invest in TIPS is through a mutual fund or exchange-traded fund that holds a diversified portfolio of inflation-protected securities. Note: Unlike individual TIPS held to maturity, the funds don’t guarantee the full return of your principal.

When to Fold ‘Em

If you purchased TIPS through TreasuryDirect.gov, the government will deposit the proceeds in your bank account on the day the securities mature. You can also sell TIPS before maturity to other investors on the secondary market using a brokerage account. The price you receive will depend on prevailing interest rates, and it’s possible you might not recoup your original investment.

How They’re Taxed

TIPS are exempt from state and local taxes, but not federal taxes. The IRS will tax the interest you earn as ordinary income in the year you receive it.

At the same time, you will be taxed on any inflation increase in principal during the year, even though you won’t pocket the gain until you sell the bond, or it matures. This is often referred to as a tax on “phantom income.”

Sidestep this tax.

Purchasing TIPS on the secondary market through a tax-deferred retirement account, such as a traditional or Roth IRA, can help avoid taxes on “phantom income.”

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© 2022 The Kiplinger Washington Editors, Inc.
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