# Inflation Protection and Taxes

It’s important to understand that inflation protection is removed when taxes are applied.  Current tax rules disregard inflation, and as a result it’s easy to demonstrate that inflation can cause all of our interest on a TIPS and some of our principle to be lost through taxation alone.

When we consider our inflation adjusted returns, we can easily see that the real tax rate climbs to astronomical levels.  This simple example shows how easy it is for taxes to use up all of our real returns.

## A Revealing Example

Let’s consider the effects of taxes on our inflation adjusted gains.  These adjusted gains are what finance professionals call our “real” gains.

Let’s use the actual TIPS that is being offered as I write this and our current inflation rate.  Our current inflation rate is actually 2.2% but we will use 2% make it easier and more conservative.  If you buy a \$1000, Ten year TIPS with a 0.5% interest rate and experience inflation that averages about 2% during that time, the overall real gain would be 5% over 10 years and the overall inflation adjustment if it stayed the same during that period would be 20%.

After 10 years, your principle would be adjusted to \$1,200 and you would have been paid about \$60 in interest.  The problem is that you are not taxed on the just the \$60.  The tax rules require that you be taxed on the \$60 real gain + the \$200 of principle adjustment.  If you are paying taxes at a low 15% rate, the rules say that you must pay 15% of \$260 or \$39.  Since you really only earned \$60 in real value, you will have paid 65% in taxes.

That’s a very high tax rate for sure, but look what would happen if we had an unusual amount of inflation.  This is something we need to consider because our intention is to protect ourselves from both average and unusual changes in inflation.

Let’s change the average inflation to 5%.  After 10 years, your adjusted principle would now be \$1500 and your 0.5% interest would be \$75.  Your tax on \$575 at 15% would now be \$86.25.  Since you only really earned \$75, taxes will have taken all of your real gain and forced you to take a loss of \$11.25 on top of that.  That comes out to be a real interest rate of -0.1125% and a real tax rate of 115%.

In a taxable account, the greater the inflation, the less the protection.  I can’t honestly say that it provides any protection at all because a taxable account amplifies inflation.  It is wrong to assume that our savings is inflation protected just because we hold a TIPS.

## One Safe Place

If you open a tax advantaged account such as a 401k or an IRA at a brokerage that allows you to hold TIPS within it, your savings is guaranteed to be protected.  That’s because all growth in a tax advantaged account is either not taxable or tax deferred.  This means that all inflation adjustments to your TIPS principle will only be taxed once, either before you put it into a Roth IRA or 401k or after you take it out of a traditional IRA or 401k.

The combination of a tax advantaged account and TIPS is currently the only option that I am aware of that will guarantee inflation protection to a person attempting to save money in United States.

## I Bonds are Only Guaranteed in Certain Cases

I Bonds are tax advantaged in that they are exempt from state and local taxes.  That makes them an even better option than other “safe” investments.  This still does not protect them from a total loss of real gains through federal taxation on inflationary gains.  There is one more advantage though.  If an I Bond is used for tuition, it is tax free and becomes a great way to save for a child’s education.

It is also possible to sell your I bonds at a time in which your taxable income is below your exemption allowance.  If your total income falls below the your permitted exemption, then your I Bonds are tax free for that year.

## A Problem for All Investments

It’s very important for all investors to understand that this problem exists outside of TIPS and I Bonds.  As far as I know, all investments have the potential of losing all of their real gains through taxes that are amplified by inflation.  Here’s an explanation of the effects on capital gains:

It’s not just a problem for investors, though.   Inflationary gains are taxed in your very own bank account.  Your interest may be only \$1 per year, and you may have actually lost \$5 of purchasing power in your account.  You would think that would mean that you lost \$4 in purchasing power.  Since you pay taxes on your inflationary gain of \$1, it pushes the loss even lower than \$4.  Inflation amplifies your taxation because the more inflation there is, the more tax you pay.

If you have the ability to have 401k, I highly suggest that you do that.  IRAs only allow you to contribute \$6,000 per year for those under the age of 50 and \$7,000 per year for those over 50.  401k’s allow you to hold far more depending on your income.

If you are a high-income individual.  You currently have no guaranteed protection from inflation for savings that I know of.  It may be a good idea to consider moving your investments overseas.  There are several nations that don’t have capital gains taxes including Mexico and New Zealand.

# Introducing Treasury Inflation Protected Securities (TIPS)

Treasury 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.

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.