TIPS on
Inflation-Proofing
Your
Portfolio |
Last
week, the Federal Reserve left interest rates alone but
indicated its concern about inflation. What will happen
in the future is obviously uncertain, but no matter how
high inflation may go, there are a couple of government
investment vehicles that provide
protection:
U.S. Treasury Inflation
Protected Securities, or TIPS, have been around
since 1997.
|
Statement from the
Fed
"The Federal Open Market
Committee decided
(5/9/07) to
keep its target for the federal funds rate at
5-1/4 percent...
Core
inflation remains somewhat elevated. Although
inflation pressures seem likely to moderate over
time, the high level of resource utilization has
the potential to sustain those
pressures.
In these circumstances,
the Committee's predominant policy concern remains
the risk that inflation will fail to moderate as
expected. Future policy adjustments will depend on
the evolution of the outlook for both inflation
and economic growth, as implied by incoming
information." |
|
|
They are
marketable securities with principal and interest
payments that are adjusted for
inflation.
Series I U.S. Savings
Bonds (I Bonds) are an
inflation-adjusted version of the more-familiar
Series EE Savings Bonds.
TIPS
Basics
TIPS Notes and Bonds are issued in terms of 5, 10,
and 20 years. Cash interest payments are made twice a
year.
Recent issues have paid interest
rates ranging from a high of 4.25 percent to a low of
1.625 percent. Of course, these interest rates sound
pretty low, but please keep reading to find out about
the inflation-adjustment feature.
TIPS investors receive an inflation-protected rate of
return in the form of:
- The semiannual cash interest payments (at the
fixed stated interest rate), based on
inflation-adjusted principal balances, plus
- A larger inflation-adjusted principal payment at
maturity or upon sale in the secondary market.
At maturity, if
inflation has risen and increased the value of the
underlying security during its term, the U.S. Treasury
pays you the higher inflation-adjusted principal.
On the other hand, if deflation occurred over the life
of the security and decreased the security's value,
Treasury pays you the original face value of the
security.
In contrast, people who invest in garden-variety
Treasury Notes won't receive anything to compensate them
for higher-than-anticipated inflation.
Key Point: Like other debt instruments with
relatively long periods to maturity, the market prices
of TIPS Notes and Bonds fluctuate daily due to interest
rate changes and other economic factors. However,
interest rate changes that are due solely to
expectations about future inflation rates should not
drastically affect the market prices of TIPS
instruments. (Daily prices and yields on all U.S.
Treasury debt securities, including TIPS, can be found
in The Wall Street Journal and other sources.)
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Tax
Planning
Implications: |
With
TIPS, the only bad news can be the tax rules. When
you hold TIPS in a taxable account, you must pay
current federal income taxes on both the cash interest
payments and the inflation adjustments to the
principal of the TIPS Note or Bond. Of course, taxes are
due at your regular federal income tax rate, which can
be as high as 35 percent.
Paying high ordinary
rates is not good, because you won't actually collect
any TIPS principal adjustments until the issue matures
or is sold in the secondary market. Nevertheless, the
U.S. Treasury wants its share now.
Fortunately, there's an easy solution to this tax
dilemma. Only buy TIPS for tax-advantaged retirement
accounts such as traditional or Roth IRAs, 401(k) plans,
Keoghs and SEPs. That way, the unfriendly tax treatment
has no impact, because the TIPS are safely ensconced in
a tax-deferred or tax-free account.
Putting TIPS into retirement accounts makes sense
anyway, because one of investors' main concerns
should be protecting their retirement nest eggs
against inflation. So TIPS and tax-advantaged retirement
accounts are a good match.
TIPS can also be held in taxable accounts, but this
generally isn't advisable unless you're in a very low
tax bracket (like the 0 percent or 10 percent bracket).
If you insist on holding TIPS in a taxable account, the
cash interest payments and principal adjustments are
exempt from state and local income taxes ... at least
that's a plus.
Key Point: Another good reason to not
hold these investments in taxable accounts is
to avoid the complicated original issue discount (OID)
rules that potentially apply whenever marketable debt
securities, including TIPS, are purchased at a
discount.
How to Buy: The minimum face value for TIPS
Notes and Bonds is $1,000. Larger denominations are
available in $1,000 increments. TIPS can be easily
bought and sold in the secondary market through your
broker, with commission charges that are generally
reasonable. Transactions can be handled over the phone
in just a few minutes. Also, several mutual funds are
now devoted to investing in TIPS.
Finally, TIPS can be purchased upon original issue
directly from the government through the Bureau of the
Public Debt's online Treasury Direct program,
which does not involve commission charges. Click here for more information.
However, Treasury Direct is available only for taxable
accounts.
Another
Inflation-Adjusted Option: I Bonds
Beyond TIPS, there's another type of
inflation-protected U.S. Treasury security: Series I
U.S. Savings Bonds (or I Bonds).
I Bonds earn
interest for up to 30 years or until redemption,
whichever comes first, and receive favorable tax
treatment. The investor doesn't owe tax for the
accrued interest until the I Bonds mature or are
redeemed for cash. So the federal income tax bill on I
Bond interest can be deferred for up to 30 years. As a
bonus, I Bond interest is completely exempt from state
and local income taxes. (The same is true for EE
Bonds.)
Unlike TIPS, I Bonds are mainly intended for small
investors. Also unlike TIPS, I-Bonds cannot be
held in tax-advantaged retirement accounts (the same is
true for EE Bonds).
Specifically, paper I Bonds can be purchased at face
value at most financial institutions in the
following denominations: $50, $75, $100, $200, $500,
$1,000, $5,000, and $10,000. Electronically held I Bonds
can be purchased direct from the government over the
Internet. Click here for more
information.
The maximum annual investment is $30,000. They can be
redeemed for cash any time 12 months after purchase or
later. However, redemptions within five years of
purchase are hit with a penalty equal to three month's
worth of interest.
Here's where the inflation-protection part comes in.
The I Bond's interest rate is composed of two separate
rates:
- A fixed rate of return determined at
issue that applies for the entire 30-year life of the
Bond and
- A variable rate of return equal to the
current inflation rate, which is redetermined on a
semiannual basis.
In computing the fixed part of the rate, the I Bond
principal is increased to account for inflation. When
all is said and done, the current annual rate,
including the semiannual inflation adjustment, is
3.74 percent for all I Bonds issued between 5/1/07 and
10/31/07.
To summarize, there are a couple of I Bond
advantages. First, they qualify for favorable tax
treatment. Second, they can be purchased in small
denominations, which makes them ideal for small
investors, like kids saving for
college.
Remember to store paper I Bonds in
a secure place such as a safe deposit box. If you have
any questions about Inflation-Proofing your portfolio,
call Ronald J. Cappuccio, J.D.,
LL.M.(Tax) at (856)
665-2121.
