TIPS For Keeping Up With Inflation

February 2008

As oil prices flirt with $100 per barrel and the value of the U.S. dollar sinks, inflation might pick up. Higher inflation, in turn, can damage your portfolio. One way to protect yourself is to put some money in investments that will act as inflation hedges. For example, you can buy Treasury Inflation-Protected Securities (TIPS).

Safe and Sheltered
TIPS are Treasury bonds, so they are protected against default by the federal government. As is the case with all Treasury issues, the interest income from TIPS is exempt from state and local income tax.

You can buy new issues of TIPS with 5-, 10-, or 20-year maturities. They can be ordered, generally without a fee, at www.treasurydirect.gov. If you don't want to buy and hold TIPS on your own, there are several TIPS funds in which you can invest. They're available from fund families such as Fidelity and Vanguard.

Up with inflation
Despite the similarities noted above, TIPS are different from other types of Treasuries. If you invest $10,000 in a standard Treasury paying 4.5%, for example, you'll collect $450 in interest each year. At maturity, you'll get your $10,000 back.

With TIPS, the interest rate might be only 2%. Why settle for a 2% yield when you could get 4.5%? Because TIPS increase in value, to keep pace with inflation.

A matter of principle
Say you invest $10,000 in TIPS paying 2%. Suppose that inflation is running at a 4% rate. TIPS pay interest every six months, and their principal is re-set then. If inflation is 4%, the six-month re-set would be half that amount: 2%.

Now the TIPS you bought for $10,000 would have a face value of $10,200, including the $200 (2%) inflation adjustment. And so on, every six months. Over the years, your principal might grow to $10,500, $11,000, $12,000, or more, depending on the inflation rate.

Moreover, TIPS investors enjoy compound growth of principal. In our example, TIPS bought at $10,000 were worth $10,200 after six months. If the inflation rate remains at 4%, another 2% increase would result 6 months later. This 2% increase would be based on the re-set value of $10,200, so the inflation adjustment would be $204, and the TIPS would be worth $10,404 after one year.

Increasing interest
In the example above, the fixed interest rate was set at 2%. Although the rate is fixed, the interest payments aren't. As TIPS principle increases, that 2% would be paid on the inflation-adjusted principal. Suppose the TIPS you bought for $10,000 reach $12,000 in inflation-adjusted principal. The 2% interest rate would amount to $240 (2% of $12,000), and the semi-annual interest payment would be $120.

Bottom Line
Suppose that you bought 10-year TIPS with a 2% interest rate. Further suppose that inflation averaged 4% per year for those 10 years. Your ultimate return would be 6% per year: 4% in principal adjustments and 2% in interest payments. You would be better off with TIPS than with a standard Treasury issue yielding 4.5%. In fact, if TIPS pay 2% when Treasuries of the same maturity pay 4.5%, TIPS would be a better choice as long as the inflation rate exceeds the 2.5% difference.

The TIPS tax trap
When you invest in TIPS, you will owe tax each year on both parts of your return - the increase in principal value as well as the interest. Thus, you'll owe tax on money you might not receive for years. Suppose you receive $200 in interest payments from TIPS this year, while the principal grows by $400. You'll owe tax on $600 of income but have only $200 in hand. One solution is to hold TIPS in a tax-deferred retirement account such as an IRA. You won't owe tax until the money comes out of the IRA, so you'll avoid paying tax on "phantom income."

The situation is trickier if you expect to live in a high-tax state when taking money from your IRA. Withdrawals will be subject to state and local income tax, so you'll be losing the benefit of the tax exemption offered by Treasury bonds. Our office can help you determine if it makes sense to hold TIPS in a tax-deferred retirement account.

Annualized Inflation Rates
1997 through 2006	2.4%
1992 through 2001	2.5%
1987 through 1996	3.7%
1982 through 1991	3.9%
1977 through 1986	6.6%
1972 through 1981	8.6%
1967 through 1976	5.9%
1962 through 1971	3.2%
1957 through 1966	1.8%
1952 through 1961	1.3%
Source: Morningstar

(Information provided courtesy of the AICPA)

Toscano & Ardito, P.C.
40 Bayfield Drive
North Andover, MA 01845
Tel. 978-688-2880
Fax 978-688-2759

Contact Us:

info@tandacpa.com

Disclaimer