How to Calculate a TIPS Inflation Adjustment

Calculator Pen Tablet

Treasury Inflation Protected Securities (TIPS) have the properties of a bond.  Since bonds are just a kind of loan, we can expect to get our money back when the loan period is over.  What makes TIPS especially attractive, however, is that the principal value is adjusted for inflation over time.  This eliminates a bond’s worst enemy.  This valuable feature does have a drawback, though.  There’s more complexity in determining what the value of a TIPS bond is.  Not only are there two ways to consider the value as I discuss in the article: Two Ways to Look at TIPS, the value of the principal is constantly changing.

If you’re a saver like me, you are probably interested in the current value of the principal of your TIPS.  In order to determine that, we need to adjust the bond’s face value by all of the inflation that has been experienced up to now.

Adjusted Principal

The adjusted principal of a TIPS is the amount of money that you would receive if the bond were due today.  You can’t get that money today, but it is the what it would be worth if it were due.  For those of us with a strategy to hold the bond until maturity, this is a meaningful number.  It gives us a view into how much inflation we have been protected from so far.  It is also the number that indicates how much interest you will get on the next coupon.  If our coupon (interest) rate is 1%, that 1% is not calculated on the face value of the bond, but on the adjusted principal.  That means that your interest is going up with inflation too.

Three Step Overview

It’s actually pretty easy to calculate your TIPS current value.  The basic procedure is this:

  1. Get the CUSIP of your TIPS
  2. Go to TreasuryDirect and look up today’s inflation “index ratio” for your specific TIPS.
  3. Multiply the index ratio by the face value of your TIPS.

That’s really all you have to do.  If you hold several different TIPS with different CUSIP numbers, you will need to repeat this process for all of your CUSIP’s.

TIPS CUSIP’s

Every bond that is tracked by the public market has a special identifier called a CUSIP.   There are thousands and thousands of these but they each identify a single bond issue.  When you purchase a TIPS at your brokerage or online you will see your CUSIP for the bond on you “trade confirmation.”  For this example we are going to use the current 10 year TIPS CUSIP and that is: 9128283R9.  This bond was originally issued on 1/18/2018.

Finding your TIPS Index Ratio
Index Ratio Table at TreasuryDirect

The index ratio for a TIPS is a number that you multiply with the face value of your TIPS in order to determine it’s current real value.  TreasuryDirect keeps track of all of these numbers for every TIPS that is currently available on the market.  Every day there is a new index ratio for every bond.  You can look up the index ratios for your TIPS by going to this page on TreasuryDirect:

TIPS/CPI Data Page

When you open this page, you will see all of the CUSIP’s listed for every TIPS that hasn’t matured yet.  Then, you click on your CUSIP number.  When I click on the number 9128283R9, I get a list dates along with some other numbers in a table.  For the sake of my example, lets say that it is April 28th.  To get the Index Ratio, I would go down the list to 4/28/2018 and then go over to the Index Ratio column and see the number: 1.00897.  You will need to get this number for every TIPS that hold.

Calculating the Adjusted TIPS Value

The last step is easy.  For each one of your TIPS that you now have an Index Ratio for, you just take the total face value and multiply it by the Index Ratio.  That is your adjusted principal value.

For my example, let’s say that I have two TIPS bonds with the CUSIP 9128283R9 with an original face value of $1000.  My total face value for both is $2000.   Then multiply that by the Index Ratio I looked up: $2000 x 1.00897.  The resulting current value is: $2,017.94.  This tells me that my money is currently being protected from $17.94 of inflation.

If I had quite a few different TIPS with many different CUSIP’s, this might take a little while to do.  You can make it go a bit faster by getting my free TIPS Tracker Spreadsheet.   I hope to make this process much faster when the new software is released.

So, that’s how you do it.  It’s pretty neat to see your money go up in value, especially on days when the stock market is down.  I urge you to give it a try and experience it for yourself.

Two Ways to Look at TIPS

Thinking FrogTreasury Inflation Protected Securities (TIPS) protect investors from inflation by automatically adjusting the original face value of the bond for inflation.  What I have discovered is that this feature is used for different purposes by different people.  I tend to use TIPS as a method of saving principal, but there are those who use TIPS as a “hedge” against inflation within a larger portfolio of riskier investments.

The Saver’s View

I discovered that the way that I look at TIPS is much different than the way investors tend to look at them.  Since I look at TIPS as a way to save money for the future, I’m not very concerned about my returns.  I’m just trying to preserve the returns that I have already received.  I’m also trying to make sure that all of this money is available on a specific date.   I also intend for that money to be adjusted for inflation.

The Investor’s View

When investors use TIPS, they are usually trying to make sure that if there is a downturn in other investments that are sensitive to inflation, that they own something that counteracts inflation.  This allows their portfolio to lose less money or perhaps even gain money as a result.

Very Different Intentions

These two perspectives come from two very different intentions on the part of the bond holder.  One person is trying to preserve and the other is seeking opportunity.  This is why I recommend that you divide your money into two parts as I describe in the article: Stressed about Savings? Divide and Conquer!

The Investor’s Bond Market Focus

When we look at TIPS from the perspective of an investor, we are more concerned with counteracting inflation.  This can be done by trading bonds that are sensitive to inflation.  To TIPS traders, the current market value is more interesting than the adjusted principle.  An investor is less likely to hold a TIPS to maturity.  For TIPS investors, TIPS mutual funds or ETF’s may make sense.  Trading TIPS on the secondary market may also be useful.  Bond market traders are also very interested in Yield to Maturity (YTM).  That’s because they are concerned with the return on investment.  Without a good return, it isn’t a very good opportunity.  This may not be a big deal in some investor’s minds because the inflation protection may be worth a loss in that part of their portfolio, however.

The Saver’s Inflation Protection Focus

When we look at TIPS from the preservation of savings point of view,   we aren’t interested in the market value of TIPS.  We are interested in the adjusted principle.  Since we intend to be getting this principal someday when the bond matures, that’s all we really care about.  We are more interested in seeing how well our savings is being protected, rather than seeing our yield to maturity.  As preservers of principle, we are willing to pay some or even all of our yield to make sure that we have our money when we need it.

Taxes

Taxes are a serious problem for both the investor and the saver.  This is one place where the two views tend to come together.  Taxes can make it difficult for an investor by taking money away during a successful time causing the money to not be there for a time when things aren’t so successful.  This makes swings in income even worse.

For savers, taxes can actually cause us to lose money due to inflation as I explain in the article: “Inflation Protection and Taxes.”  Since we don’t make much interest on a savings style investment, taxation can make our preservation costs unpredictable and threaten our attempts to preserve once again.

Be Careful Not to Mix Views

It can really cause you to become paralyzed as to what to do with your money if you flip back and forth between the investing and savings views of looking at TIPS.  I find that it is wise to make a conscience effort to think one way or the other when choosing what to do.   I tend to use them for savings preservation.  I see very little help out there when it comes to looking at these bonds from this perspective.  By viewing TIPS in a way that matches your needs, you will be able to make more confident decisions with them.

Where to Buy TIPS

Shopping Plate

Where you choose to buy your Treasury Inflation Protected Securities (TIPS) is very important.  As I mentioned in the article: Inflation Protection and Taxes, failing to put your TIPS into a tax advantaged account causes them to shed their inflation protection.  That’s because taxes are assessed as if inflation doesn’t matter.

You can buy Treasury Inflation Protected Securities directly from the United States Treasury at TreasuryDirect.gov.  There are detailed instructions on setting up your TreasuryDirect account in my article: How To Buy an I Bond.  TreasuryDirect accounts are not Roth accounts, though.  That means that you will not be protected from inflation losses due to taxation.

Finding an Online Brokerage Company

Instead of using TreasuryDirect to buy TIPS, I highly recommend that you open a Roth IRA account at an online brokerage company.  I have done a little research for you to make sure that there are some options, but I would not be surprised if there are many more good options.  I came up with four and they are almost the same in what they have to offer as far as TIPS go.

E Trade

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

Charles Schwab

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

Fidelity Investments

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

Things to Consider

Where you choose to hold your Roth IRA depends on your own needs and preferences.  It may be easiest to open one with a brokerage that you already use for your traditional IRA or 401k.  There are other things to compare as well, such as the fees that will be charged should you choose to leave them, so it’s good to do your homework.

Financial Advisors

If you have an advisor you trust, it might be easy to do it all through them.  Just tell them that you would like to hold your long term savings in TIPS using a Roth IRA and they should be able to take care of it for you.  As you can see, trading in TIPS doesn’t usually cost very much so it shouldn’t cost very much to just have your existing financial advisor do it for you.

If you have an advisor that is unwilling to put you into a Roth IRA or TIPS, I would consider looking for help elsewhere.  TIPS are one of the most secure investments available.  Remember that advisors are supposed to be working for you and they should be looking out for your best interests.

The Fine Print Takes Time

One of the things that really surprised me was the legal paperwork that an account holder is required to understand and agree to before opening an online account.  This creates a time cost that can easily be overlooked. It dwarfs the time it takes to enter your information and set up your account.  The fact that it is in small print and put right at the final button before you open the count should probably be illegal in and of itself, but that’s what we have to deal with right now.

When you click on that little tiny link, it exposes you to as much as 100 pages of legal paperwork that you are required to “read and understand.”  This part of the process took me about a week of reading after I got home from work.

This really hurts, but because I wanted to be honest before God and I could clearly see that I was likely to save thousands of dollars as a result, I eventually got through it.  I didn’t read the documents for all four of these brokerages.  I can only speak for Fidelity.  I did start on Charles Schwab and TD Ameritrade documents.  All of them were pretty difficult.  Schwab’s seemed a bit simpler in language but if I recall, it was about 100 pages printed.

When you read the fine print, you may want to have these links on hand to help you understand what you are reading.  These documents require that you understand jargon in three difficult professions: Tax, Securities and Legal.  Here are some helpful links:

You may even want to “share the pain” with your brokerage representatives.  That’s what I did.  If I got discouraged, I just called them up and told them that I have been going through their legal documents for a few days and I don’t understand “xyz”.

Funding the Account

There are several ways that you can fund an account.  One of the easiest ways would be to roll an existing 401k account into your Roth IRA.  Before you do that, talk to your tax advisor.  In general I think this is a good idea, but your specific situation is important to consider.  Taxes will be required in the year that you do the rollover.  It may be beneficial to do a rollover each year for a few years instead.  Rollovers don’t have a penalty of 10% when you do them before age 59 and a half, but you do have to make sure to specify it as a “Rollover.”  My understanding is that you can only do a certain number of rollovers per year.  Again check with your tax advisor.

You can usually fund an account by linking your checking account to your brokerage account.  This is similar to what you might do when you pay a bill online.

You can also just send a paper check by mail to your brokerage.  They should have a deposit slip that you can get with your account number on it after you set up your account.

The road is quite narrow to protecting your savings from inflation here in the United States.  Even though it’s not easy, it’s worth it to get your brokerage Roth IRA account open and ready to make it possible.

How to Buy an I Bond

Picture of the front page of the Treasury Direct website

If you looking to buy an I Bond, but you’re not sure where you need to go or what you need to do, you’ve come to the right place.  Just follow these simple step-by-step instructions.  They will help you set up your TreasuryDirect.gov account and buy your first I Bond.  If you have a printer, you may want to print these instructions so that you don’t have to go back and forth between these instructions and TreasuryDirect.

This could take 15 – 30 minutes.  It’s good to take your time.  There’s no reason to hurry.  I suggest doing this on a computer, not a cell phone because you may be asked to allow your computer to use “Flash.” One of the demos provided at TresuryDirect uses Flash and should work fine on IE, Edge, Firefox and Chrome  browsers.

If you are wondering why you would want to buy an I bond, please read the articles: “I Just Want to Save My Money!” and “Why Bonds are Smart for Savings“.

Step 1: Gather Your Info

You need to be a “U. S. Person” and have a Social Security Number in order to buy U. S. savings bonds.  It’s one of the special privileges you have just for being a United States citizen.

You will need an address in the United States if you want to participate in buying I Bonds directly from the government, so have that ready too.

You will need to have a checking or savings account so that you have a way to pay for your I Bond.  You can’t pay with a credit card but it’s ok if you don’t have paper checks.  You just need to call your credit union or bank and get your checking account’s routing number and account number so you can pay Treasury Direct with electronic checks.

Like most online services these days, you will need to provide Treasury Direct with a valid email address.  They intend to contact you electronically with information about your account.

You have to have a computer with a browser that can create a private line to Treasury Direct.  Pretty much all computers for the last ten years have been able to do this.  The computer you are using to read this should work as long as it is a private one.  It’s probably not a good idea to do your finances on a public computer.

Step 2: Take the Guided Tour at TreasuryDirect.gov
Picture of the TreasuryDirect Guided Tour page

Although this government site has its own oddities, they’ve done a great job of holding your hand through the process of setting up your account.  You and anyone in your household that has a Social Security Number is entitled to have a free account directly with the United States Treasury.  They have a pretty nice “Guided Tour” that shows you the steps that you will go through when you set up your account.  Here it is:

TreasuryDirect.gov’s Guided Tour

If you need to type the address in, here it is:

https://www.treasurydirect.gov/indiv/TDTour/default.htm

Step 3: Complete the Application Process at TreasuryDirect.gov

The application process will allow you to set up your TreasuryDirect.gov account by entering the information that you have collected.

From the Guided Tour page, you can find the application link in the upper-right corner of the page.  It’s called “OPEN YOUR ACCOUNT NOW“.  At the time that I write this, the letters are pretty small but they are all orange.

f you are on the Treasury Direct starting page, you will find the place to open the account underneath the orange login button.  Just click on the words: “Open an Account

Make sure that you record:

  1. Your new account number
  2. Your new password
  3. The answers to your security questions (they will ask them sometimes and it will lock you out if you don’t answer them correctly)

It’s a good idea not to save these things on any computer or cell phone.  You might consider writing these down and saving them with other vital records and information you keep.   Physically locking the information in a safe would be one good idea.

Step 4: Watch the Accessing Your TreasuryDirect Account Demo
Accessing Your TreasuryDirect Account Demo Page

The TreasuryDirect site has quite a few security features.  It’s a good thing but it also makes it a bit harder to use.  I highly suggest that you watch the Flash Demo that they have created at the TreasuryDirect.gov site.  You can click on the graphic on the right or  click here.  Make sure that you say “yes” if your browser asks if you want to us “Flash”.

Here’s the address if you need to type it in:

https://www.treasurydirect.gov/indiv/myaccount/myaccount_demo.htm

Step 5: Sign In to TreasuryDirect

To log in, locate the “Account Login” section in the upper right corner of the TreasuryDirect.gov website.

Select the “TreasuryDirect” link in that section. On the next page, select the orange “LOGIN” button.

If this is the first time that you have logged in, you may be asked to check your email for a special passcode.  This is a security protection to make sure that it is really you.  You must enter that code that you get from your email.  You can choose the option to allow TresuryDirect to remember your browser.  That way you won’t have to get special codes in your email every time you attempt to log in.

On the next screen you must enter your new Account Number.  That’s not the passcode.  That’s the one that you used when you first applied in step two above.  After typing in your account number, hit the “submit” button.

You will then be taken to a screen that allows you to choose an image and a phrase.   This might seem a bit silly, but it is actually a good security method.  TreasuryDirect will show you this picture and phrase every time you log in.  It’s a way for you to know you are actually accessing TreasuryDirect and not a fake.

If that image is ever not the one you remember. It’s a good idea to close your browser and contact TreasuryDirect by phone and tell them that something is wrong before going on.  All these things are there to make sure that you are protected and that’s a good thing.

Below that you will see a graphical keyboard.  Instead of typing your password using your keyboard, you need to type your password using the graphical keyboard, with your mouse.

After you hit the “submit” button, the weirdness is pretty much over.  You will now be signed into TreasuryDirect.  You should see a welcome message with your name at the top of the screen.

One other strange thing to keep in mind about the TreasuryDirect website: Don’t try to use your “back” button in the browser.  That will force you out, requiring you to log in.  TreasuryDirect will only allow you to use the buttons on the page to navigate.  All these things help the web site give you a very secure environment.

I did find some graphical instructions at WikiHow that may also be very helpful.

Step 6: Buy Your I Bond

Now for the fun part.  We are finally to the point at which you can buy your first I Bond.

Now that you have logged into your account, you will need to click on the button at the top called: Buy Direct

You will then see a list of options of things you can buy.  In the list you will see an option for “Series I – An accrual-type security with a combination interest rate of a fixed and an inflation rate”

Select that option and Hit the blue Submit button.

You will a place to enter your “Purchase Amount“.  Enter the bond amount here.  You can have a bond as low as $25 and if this is the only bond you plan on buying this year, you should be able to have one for as high as $10,000.  I haven’t tried that before but it should work as long as you have the money.  Make sure that the “Select a source of funds” drop-down box shows your checking account and then hit the “Submit” button.

That’s it.  When you log back into TreasuryDirect, you will be able to check up on your I Bond and see its current value.  This is also the place to go when you are ready to sell your bond.  You can’t do that for the first year, because that’s one of the rules.  It’s best to hold on to your bond for five years so that you get all the interest.

You can also buy other kinds of treasury investments this way including TIPS.  That’s all it takes to take advantage of one of the safest and most effective ways to save for your future.

10 Articles About Inflation Protected Bonds

Tree Under Umbrella

source: freeGraphicToday (Pixabay)

Here’s a list of 10 articles I found that provide information about Inflation Protected Bonds.  Learn more about how I Bonds and TIPS work and good reasons to use them for long-term savings.

Zvi Bodie: I Bonds Are Best for Most Investors

by ThinkAdvisor.com

This is an interview with Professor Zvi Bodie about the safest way to invest for your retirement needs.  He explains the clear benefits and why he believes that more people need to hear about this ultra-safe way to prepare for retirement.

What are I Bonds?

by www.ibonds.info

This overview of I Bonds briefly explains their benefits and how they compare to other investments in general.  It describes I Bonds as a safer investment than other kinds of investments.  It has some very helpful graphics.  I believe is the best site about I Bonds I have found.  You might want to spend some time here looking around at all it has to offer.  This site also sports an up-to-date display of the current interest rate being offered by I Bonds in the upper right hand corner and contains great quotes that people have made about the benefits of I Bonds.

Fixed income that isn’t fixed

by Fidelity Viewpoints, Fidelity Investments

This article provides a good overview of TIPS from an investment perspective.  It also has a discussion about ETFs that give smaller investors access to something called Floating Rate Loans.  I’m not a fan of those at this time, but this article does have a discussion of those as well.

Hedge Your Bets With Inflation-Linked Bonds

by Christina Granville, Investopedia

This article give some great background on the history of Inflation Linked Bonds and provides a brief overview of how they relate to investments in an investment strategy.  I tend to not care about investment strategies in that I use inflation protected bonds for long-term savings.  This article also provides the names the inflation protected bonds available in other countries.  Don’t get too concerned about the discussion about deflation.   She mentions at the end, it doesn’t apply to those of us using it for long-term savings.  I intend to address that issue in another article.

The Investment TIPS You Should Care About

by Wade Pfau on Forbes

This article is directed toward those of you who already think in investing terms.  It’s a bit technical compared to some of the other articles.  The author discusses some of the oddities regarding TIPS and their relationship to other bond investments.  He briefly discusses the idea of real and nominal yield and the difference in thinking that goes along with investing in TIPS.

TIPS: Understanding Treasury Inflation-Protected Securities

by Dan Caplinger on The Motley Fool

This is a great article that covers the history that the United States had with the bond market and inflation during the 1970s and 80s.  It does a great job of explaining the benefit and protection that TIPS provide.  The article concludes by recommending ETFs and Mutual Funds.  I’m not a huge fan of funds.  I hope to explain my viewpoint in a future article, but I have held them at times because I believe that they are some of the safest ones to hold.  This article is not very technical and a great one to read to get some background on TIPS.

Negative TIPS Yields

by Thomas Kenny at The Balance

One of the most alarming and confusing things to discover about investing in TIPS is that they can show a negative yield during certain times in the economy.  This article explains why that happens.  This is another topic I hope to make more clear in the future as well.  It’s good to note that your bank account has been giving you negative yields for several years in a row when you adjust your returns for inflation.  TIPS are just more easily exposed when this happens.  You can choose to not buy TIPS when they go negative.

Tracking Inflation and I Bonds

by TIPS Watch

This is a page on a site all about TIPS that tracks the interest rates of I Bonds.  It also explains how I Bond rates are calculated.  If you want to see the history of I Bond rates, you can see that on this tracking page.

Series I Savings Bonds

by Treasury Direct

This is the United States Treasury Department’s information on I Bonds.  You can get all of the most accurate and latest information here including the current interest rates and how they are calculated.   If you want to buy them, you are only a few clicks away.

Treasury Inflation-Protected Securities (TIPS)

by Treasury Direct

Here is the United States Treasury Departments description of TIPS.  This is where you will find the most up-to-date information on them.  It’s not that hard to understand but you may need to invest a little time reading and thinking about it.  I don’t think you need to know much about investing to understand what it said here.  You can also buy TIPS directly from this site.

 

Bonus Articles

How to Buy an I Bond
If you are ready to buy an I Bond but don’t know how to get around at TreasuryDirect.gov, I can help you with that here.

Stressed about Savings? Divide and Conquer
You might consider a strategy that separates savings from your more risky endeavors. Here’s how I like to think about it.

Inflation Protection and Taxes
Taxes are a real problem when it comes to inflation protecting your savings. Learn more about that here.

Introducing Treasury Inflation Protected Securities (TIPS)

Bill in wood chestTreasury Inflation Protected Securities or TIPS, are one of the most valuable tools we have here in the U.S. to protect our savings from inflation.  In this article I provide a simple overview of what they are and how they work.

TIPS are really just a type of bond offered by the United States Treasury.  The United States Treasury has been offering bonds since 1935, but TIPS have only been offered since 1997.  The thing that makes TIPS bonds different from other bonds offered by the Treasury, is that these bonds are “indexed” to inflation.  Indexing a bond means that something about the bond varies with an index and an index is just a way of measuring something else.  TIPS bonds are indexed to an the CPI-U which is maintained by the United States Bureau of Labor Statistics.  That index is also called the Consumer Price Index.  It’s a measure of the cost of a broad range of things that we buy in the United States.  The CPI-U is a great topic for another post, but for now it’s enough to say that the CPI-U is a well established way to track inflation in the United States.

The United States Treasury sells these inflation protected bonds through their public web site: treasurydirect.gov.  That’s the same site you use to get I Bonds.  Here’s definition of TIPS at Treasury Direct:

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.

See: Treasury Inflation-Protected Securities (TIPS) at Treasury Direct

If you are new to the whole idea of “bonds,” there is a simple way to think about them.  A bond is really just a loan that you provide to someone else.  When you “buy” a bond, you are acting like a bank.  You didn’t really buy anything.  You actually loaned that money.  Instead of paying interest to someone else, they pay interest to you!  In the case of TIPS, you are loaning your money to the United States Federal Government.  So you can think of a bond like a piece of paper that says that someone owes you money, even though we don’t use paper anymore.  It gets a bit weird when you consider selling that piece of paper to someone else.   For our purposes, I would only consider that in an emergency situation.

The nice thing about loaning money to the federal government is that they tend to pay you back.  The kind of bonds that may not pay you back have a special name that you may have heard before.  They are frequently called “junk bonds.” The U. S. government bonds are likely to be paid because the government has a lot of control over our money.  The down side to loaning to the federal government is that they tend to not pay a lot in interest, but when you are just trying to save your money, it’s more important to find a safe place than it is to make money.  There are many more risky ways to invest your money that allow you gain (or lose) in higher amounts.

So, lets talk about how TIPS protect us from inflation.  If you have borrowed money before, you may have recognized that the amount that you borrowed was called “the principal.”  With TIPS, the amount that we initially loan to the government is called the principal, but it is “adjusted” over time with inflation.

For instance, if I loan the government $1000 using a TIPS, and the inflation rate is 3% and a year goes by, your principal would be “adjusted” by the government to be $1030 because of the inflation.  If inflation kept going up at 3% for the next year, they would adjust the principal again to $1060.90.  You don’t have to do anything and your loan amount automatically goes up!

One thing that I need to explain before going on, is the concept of “bond maturity.”  Bonds are loans that have a limited amount of time associated to them.  When a bond matures, you get your money back and the loan is over.  Time for that bond is up and you have to be paid back.  TIPS currently come in three sizes: 5 year, 10 year and 30 year.  It’s good to keep that in mind because you wouldn’t want to get TIPS like this if you think you might need the money sooner than 5 years.  This has to be money you are storing away for the future.  The fact that the date is right on the bond, though, makes it great for storing your money for specific future things, like a big vacation, college for kids, or retirement.  The government has promised to pay you back on a specific day and that’s the day the bond matures.

“Ah,” you say, “but what about deflation?”  That’s an important question.  What goes up must also come down, and TIPS will go down too, but TIPS have a special feature built into them.  You can never get less than the “face value” of the bond back at maturity.  Face value is the term they use to express the amount of money that the bond represented when it was first issued.   That actual principle is still protected from deflation.  If we happened to go through a time of deflation and the bond comes due at that time, you are sure to get your original amount returned to you.  For instance, if you purchased a $1000 5-year TIPS and you had five strait years of deflation that left your adjusted principal  at $900, at maturity you would still get the full $1000 back.  You would have actually earned $100 in purchasing power because things are cheaper to buy.

There’s even more good news about TIPS.  The government does pay some interest to you for loaning them money.  At the time I write this, there hasn’t been a whole lot of interest being offered for quite a while.  The last 10 year TIPS had an interest rate of 1/2 of a percent.  That’s probably not anything to write home about, but it can add up over time.  1/2 of a percent of interest on a TIPS is a lot more than what it seems on the outside.  It’s like a little secret that stays a secret because it’s confusing to people, but here’s how it works.

According to the Treasury’s statement above, your interest is paid twice a year on your “adjusted principal.”  Remember, that’s the loan amount that has been adjusted for inflation.  Using the example above, if I took that adjusted principal of $1060.90 and calculated the interest payment for the year, it would be: 1060.90 x .005 = $5.30.  Now, if I didn’t have a TIPS but had a regular ole’ bond, the calculation would be this: 1000 x .005 = $5.00.  What this means is that my interest rate is also adjusted for inflation. The $5.30 of today buys the same amount of gas or hamburgers as the $5.00 did two years ago.  It’s true that 30 cents isn’t that big of a deal, but it adds up over time.  That’s the problem we are trying to deal with.

With TIPS, you get paid in “real” interest and that makes a big difference when you are trying to find a safe investment.  As you can see, you don’t get much interest, but what you do get will always have the same real value.  Now when the Treasury says you get paid twice a year, that means you have to take the $5.30 and divide it in half, because interest rates are a yearly rate.  You actually would get paid $2.65 half way through the year and another $2.65 at the end.  Of course by then, it may actually be higher because inflation doesn’t stop half way through the year.

Now I need to discuss the bad news.  It’s not so bad for those of us who are trying to protect our savings, but it isn’t something fun to think about, that’s for sure.   Perhaps you have heard of the IRS.  Well, they don’t seem to understand or care about the fact that we are simply trying to save money that we have already paid taxes on. One of the most disturbing things about the current state of personal finance came to my mind when I realized what was going on here.

The IRS doesn’t recognize those principal adjustments as “maintenance” on existing earnings.  They see them as “new earnings” and you know what that means.  Yes, that inflation adjustment gets taxed, and it gets worse.  They take the taxes out the same year it is “earned.”  That means that while you are just watching your $1000 turn into $1030, the government charges you taxes on that $30 that same year, even though your TIPS has not matured yet and you don’t have the earnings.  You are going to have to come  up with the taxes out of what you have now.  That’s when the interest comes in handy.  It can be used to pay some, or perhaps even all of your taxes, but you will have to pay taxes on those interest payments too.

If you are like me, you need to take a few seconds to calm the mind after the bad news about taxes.  There is a good thing about the tax situation to keep in mind, however.  The federal government doesn’t allow the state government to tax you on federal bond earnings.  This is the same for other federal bonds as well.

The second piece of bad news has to do with how TIPS are purchased.  It’s not like I Bonds where you just pay your money and get a bond for the amount you pay.  For TIPS, the government actually “sells” them on an auction.  Now this is hard for investing newbies (and it should be because it’s so weird in my opinion).  It’s like they are auctioning off money.  Yeah, that’s right.  They will sell $1000 for $998.70.  That’s on a good day at the auction.  When they do that they say that you are getting a “discount.”  On bad auction days, they could sell $1000 TIPS for $1020.  They call that buying at a “premium.”  I’m sorry I have to explain this but it is reality.  At some point I hope to go into the history of TIPS so you have a better understanding of why this happens.  It isn’t very common to buy 10 year or 30 year TIPS at a premium, but it has been very common for the 5 year TIPS recently.  This means that at certain times, you could lose all of your interest to the initial price of the TIPS.  There may be times that it is worth the risk to wait for a better auction.  I am discovering that for my critical savings, protection is well worth the cost.

So those are the two bad things.  Inflation protection comes at a cost at certain times in the economy.  Remember, though, that TIPS may turn into a good investment during certain times too, but I think it’s important for us to see it as a protection, and often when we protect ourselves, we have to buy something.  We spend money to protect things that are important to us.  I have learned that, even in the bad times, TIPS can be beneficial because the their protection outweighs the small amount I may have to pay extra during certain years.

Now here’s a very good thing I saved for the last.  You can put TIPS into a Roth IRA account.  Those are the retirement accounts that are tax free.  This is the sweet spot for TIPS.  When you store your  retirement money in a Roth account, you can put the money into TIPS and watch it grow along with inflation, without having to worry about taxes taking it away.   You will need to get a Roth IRA at a brokerage that offers TIPS in order to do this.

TIPS are a great way to protect your long-term savings from inflation because they are tied directly to inflation.  TIPS are not very fancy in that they come from the government, and they can be challenging to understand.  There are costs associated with TIPS such as federal tax and the possibility of high prices at auction.  I hope that this has provided you a good overview of what TIPS are and how they work.

I Just Want to Save My Money!

So, you are at the point where you have decided to stay out of the market and all you really want to do is save what you have for later.  The problem is, you haven’t found a way to save money for longer than a year or so, without feeling the effects of inflation.  A simple look at the inflation rates reveal that you would have to get an interest rate of somewhere around 2% just to break even!  With 5 year CD rates at 1.5%, you realize that you would be paying the bank half a percent to keep your money from you!  If you were an irresponsible spender, that might make sense, but you are serious about saving.  Now, am I the only one who thinks this is crazy?  Why are more people not upset about this?

Running Toward Risk

One reason might be that people have been placated by the possibility that they could make money using the stock market.  It’s hard for me to believe that this was not the intent of denying us the right to save our money.  I believe it is dishonest for any government to act like money is money if it can’t be saved for more than a few months.  It would also be pretty hypocritical for a government to complain about the number of people without savings, if they haven’t even provided a way to save this so-called money.  Well, I’m happy to inform you that they actually have provided a way to save.  There must be a few godly people in the government because they gave us a way to save money that can actually avoid much of the exposure to inflation.  In the United States, there are actually two ways.  They aren’t perfect, but they do appear to be a step in a good direction.  This information is so little known, and so important, that I really wanted to share it.

The Old Way

I’m going to assume that you are familiar with how a savings account accrues interest.  It’s important that you also understand how CDs or Certificates of Deposit work at the bank too.  A typical CD is a special account in which you give the bank your money for a dedicated amount of time with the promise from them to pay you interest.  If you take your money out early, there is a penalty.  The interest is calculated on the amount of money you initially put into the account, plus any interest accrued.  Now if that interest rate is less than the rate of inflation, you are actually losing money.  That’s because what you can actually buy with the money has become less over time, while at the same time, the interest didn’t increase fast enough to give you the same purchasing power your money had when you earned it.  So what did the United States Government do to help us in this situation?

The New Way

In 1997 the United States Treasury provided a new way of saving by issuing something called: “I Bonds. ” In order to understand what those are, you kind of need to understand what a normal “bond” is.  Stocks and bonds are really different even though they are often spoken of together.  When you “buy” a bond, you are actually loaning your money to someone.  Pretty confusing right?  It sounds like you are purchasing something when, in reality, you are loaning someone else your money!  Well, no matter what it seems like, that’s what it is.  When you buy a bond, you become the bank.  You can loan money to companies by buying corporate bonds.  You can also loan money to a government by buying government bonds.  That’s one way that United States Treasury finances their needs and they allow individuals or institutions to buy bonds.  One institution that does this is, … surprise…. your bank.  In fact, those CDs you get are often backed by government bonds.  I tell you this to help you understand that that these I Bonds are not really a new risk to you.  You are accessing the same United States Treasury only in a different way.  Let’s look at how a typical bond earns money for you.

100 Dollar Series I Savings Bond Image With Picture of Dr. Martin Luther King
source: TreasuryDirect.gov

A good old-fashioned bond used to be printed on paper, kind of like a dollar bill.  On the face of this bill, it had a value, like $100.  If you were to buy this bond at its face value you would loan the government $100 and they would give you this bill.   In those days, part of your loan agreement was that every six months or so, the government would pay you by sending you a coupon in the mail for all the interest they owed you on that money so far.  You could then go cash the coupon and use the money.  That was your interest for allowing the government to use your $100.    Another thing about your bill is that it would have a term associated with it that was recorded in a book somewhere.  That’s the amount of time you agreed to allow the government to use your $100.  When time is up, you can cash in your bill to get your $100 back.  As long as they are using your $100, they promise to keep sending you your interest as coupons in the mail.  Well, it’s pretty obvious that computers were bound to change this process a bit.

Buying Treasury Bonds Today

Now days, we use the same terms, but the paper is almost gone.  You still can buy a bond, but the coupon never gets sent to you, it just accumulates in an account.  In fact, the Treasury is willing to compound the interest now just like a CD.  Not only that, you can go to the Treasury’s web site and open an account online, just like using online banking.  Anyone with a Social Security Number is eligible.  Their website even has a clever name:

TreasuryDirect.gov

Yes, you have your very own online bank account waiting for you, but wait, there’s more.  Let’s go back to talking about I Bonds.  I Bonds, or more accurately Series I Savings Bonds, are what the Treasury calls “Inflation Adjusted Bonds”.  That’s right.  They’re bonds whose interest is tied to inflation.  That means that when inflation goes up, the interest rate on these bonds go up too.  Part of the interest calculation is connected to an index that follows the cost of goods in the United States called the CPI-U.  The CPI-U is a good topic for another article.  It’s good to know, for now, that your interest rate will go up when inflation goes up.  It’s also important to understand that what goes up, must also come down.  If inflation goes down (yes that would be deflation) the rate goes down, but the Treasury decided that they would not allow your bonds to ever go below your original amount.  That means you could actually make money in a deflationary time as well.  If you want to buy an I Bond, I have step-by-step instructions available at this website.

The Tax Problem

Now let’s say that you are convinced and you’re ready to put some of your savings into one of these I Bonds.  First, let’s talk about the down side.  I Bonds, unfortunately, are not protected from taxation by the IRS.  The United States Tax Code, for some reason, doesn’t recognize the fact that you already earned this money once.  Evidently, our congress believed that simply recovering your money’s lost value to inflation is a taxable event and that we owe money for that.  This means that you aren’t completely protected from inflation.  You will have to treat your interest on an I Bond as “income” and report it.  That’s the bad news.  This same bad news spans all investments including your bank account.  That’s not much comfort, but there are two tax advantages that you also need to consider as well.

First, we are allowed to defer reporting our interest to the IRS.  You can choose to not report your interest until you need to use the money.  The reason that this is significant is that you can wait to use the money for a rainy day, such as, a year when you don’t have much income.  For many of us, that will probably be during retirement.  At that time, you may not even be taxed, depending on what other income you have.  The other advantage is that these bonds are not taxable by state or local governments, like your bank account is.  So, even though taxes make things less than perfect when trying to shelter yourself from inflation, these I Bonds are one of the best things we have.

If you are interested in learning more about the effects of taxes on our inflation-protected savings, make sure to check out my post: Inflation Protection and Taxes.

Some Important Details

Now for some important details about I Bonds:  You can buy an I Bond for $25 or more at Treasury Direct, but you can’t buy more than $10,000 in any given year.  For many of us, that’s not an issue, but there are some who would like to save more than that.  Well, there is another trick… You can use your tax return to buy about $5000 more and guess what, you will get the paper certificates!  They are pretty cool, I have to admit.  There are more pictures of them at Treasury Direct.

Also, I Bonds are a long-term investment.  They act kind of like a CD in that there are restrictions about when you can take the money out.  You can’t cash them in for the first full year.  Also, you are penalized if you cash out before a 5 year term, but the penalty is not very bad.  You would have to give up the previous three months of interest, but that’s it.  Since you probably want to save anyway so that’s not a big deal.  The good thing is that you can keep your money in this bond for 30 years!  Yes you read that right.  Anywhere from 5 to 30 years, the government is willing to keep growing your interest rate with inflation and allow you cash out any time.  After 30 years the interest stops so it’s a good idea to cash it in and get a new one so you keep earning interest.

If you are looking to shelter more than that, or were wondering how you could do something like this in a retirement account, there is another option.  Check out my post:  Introducing Treasury Inflation Protected Securities (TIPS).  Thankfully, you can save money after all!