While a general savings bond just accrues interest at a fixed rate, part of the interest on I bonds, as they are known, is based on a variable rate that keeps up with inflation. Right now, that rate is a pretty generous 3.54%. For most savers who are concerned that inflation will spike, I bonds can be a worthwhile investment.
But for wealthy investors, especially those close to or in retirement, they're a lot less useful. That's because the Treasury Department says an individual generally can't buy more than $10,000 of I bonds per year. A larger portfolio of, say, $1 million isn't going to benefit much from an inflation hedge of just $10,000.
That makes Treasury inflation-protected securities, or TIPS, a better inflation play for deep-pocketed investors. The maximum purchase amount is set at $5 million apiece for 5, 10 or 30-year TIPS when they're initially auctioned off.
These bonds work a bit differently than I savings bonds. With TIPS, the principal amount of the bond is adjusted periodically to account for inflation and, in turn, so is the interest paid out.
Another selling point is their flexibility: Investors can redeem them at any point. With I bonds, savers must hold onto them for the first year. And if they redeem them within five years of purchase, they are penalized and will earn less interest. With inflation expectations and the economic outlook overall in such flux, it's helpful to have the ability to make changes.
Remember, the point of TIPS is to provide an inflation buffer, not a high yield. Their yields are paltry relative to other bonds to compensate for the edge they give investors if inflation is higher than expected. Typical government bonds already have a predetermined amount of inflation baked into their value. TIPS are winners if inflation exceeds that expected amount.
Still, they aren't without risks or drawbacks. The initial investment in TIPS will always be preserved if held to maturity, but the interest payments could be less than you would have received from a regular government bond if there's deflation. Also, if TIPS are sold before maturity to another investor, there's always the danger of losing money because they could be worth less if rates are going up.
They also aren't as advantageous from a tax standpoint as I bonds, which could be particularly onerous for wealthy taxpayers. With TIPS, investors owe tax on the uptick in principal if it's adjusted for inflation each year, even if the bond hasn't been redeemed.
With I bonds, taxes aren't owed until the bond is cashed in. The workaround for TIPS is to hold them in tax-deferred accounts so those "phantom" distributions aren't subject to ordinary income tax rates.
If you want to add TIPS to your portfolio, you have two main options. The cheapest, most direct route is to purchase them directly at Treasurydirect.gov. You can also buy them through a bank or broker. It's often prudent to buy bonds with different maturity dates to stagger the flow of money coming in.
An alternate option for those who want to be less involved is a low-cost short-term exchange-traded fund that just tracks an index made up of TIPS. As an example, the Vanguard Short-Term Inflation Protected Securities Index Fund has returned 6.6% over the past year.
Aside from the ease, the other benefit is that funds often distribute the inflation adjustment as income even if you don't redeem your shares — so you have something in your pocket to show for the tax you pay. For taxpayers in top brackets, that goes a long way.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.
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