TIPS
are a new type of security offered by the U.S. Treasury. They are Treasury bonds,
however, they are a little different from what normally is considered a Treasury
bond. When you purchase a TIP, you will receive the interest payments semi-annually
and you will receive your original principal amount at maturity, however unlike
a regular Treasury bond, the interest and redemption amounts are tied to inflation
rates.
How a TIP Works
The
interest rate is the rate at the time of purchase and will remain fixed until
maturity of the bond. The inflation-indexed feature of the interest rate, which
is based on the Consumer Price Index (CPI), adjusts the accrued principal value
of the bond upwards each year by the amount of inflation. Essentially, what happens
is the principal amount of the bond adjusts for inflation because the interest
rate is not applied to the par value of the bond, but rather to the inflation-adjusted
principal value (there is a formula to determine what this figure is). The semi-annual
interest payments that are paid out are based on the inflation-adjusted principal
value of the bond at the time the interest is to be paid. If inflation occurs
while you hold TIPS, each interest payment will be higher than the last. In the
event of deflation, the interest payments will decrease.
At
maturity, you will either receive the inflation-adjusted principal amount or the
par value of bond, whichever is greater. If inflation has occurred, then you are
going to receive more at maturity than what you paid for the bond. If there has
been deflation, you are going to at least break even. The system is set up so
that a purchaser never receives less than what was paid for the bond.
Taxation
of TIPS
Because
TIPS are Treasury instruments, they are exempt from state and local tax, but you
will owe federal tax on the interest earned as well as on the increase on the
principal value even though you will not receive the adjusted principal value
until actual maturity of the bond. You will have reportable income, however it
cannot be used until maturity. In this sense, TIPS are very much like zero-coupon
bonds or STRIPS.
Because
of this, you should be careful as to what type of account in which you purchase
a TIP. If you purchase a TIP, you should try to purchase it in a tax-deferred
account and not a taxable account.
The
Henssler Financial Group Position
Because
most maturities for TIPS are at least 10 years or greater (normally 30 years),
they generally do not fit into our Ten Year Rule philosophy. Our philosophy states
that any money you need within 10 years should be invested in fixed-income investments
and any money not needed within the next 10 years should be invested into growth
investments. We suggest only buying fixed- income investments for specific liquidity
purposes over the next 10 years. We suggest Treasury bonds, notes, CDs, or municipal
bonds (if your tax bracket warrants), depending on interest rates at the time
of purchase. History has shown that for periods of 10 years or more, you would
be better off being invested in the stock market. If you do not need the money
within the next 10 years, then it should be invested in the market.
Remember
that you spend cash, not income. What would happen if you purchase a TIP specifically
for income purposes? This may be fine during times of increased inflation, but
what would happen in a reverse situation? The income stream you have counted on
could be reduced. Why take this chance when there are other safe and viable options?
We suggest laddering out Treasury bonds, CDs, etc., to cover your annual spending
needs not already covered by other sources of income. As these fixed-income instruments
mature each year, you would spend the principal. You would not have to worry about
inflation or what interest rates are doing because funds to cover your needs would
already be locked in.
It
is also not advantageous tax-wise to buy TIPS for those who have liquidity needs
outside of tax-deferred accounts. We believe you would be better off in a regular
Treasury bond.
There
are instances that may warrant the purchase of TIPS (if nothing more than just
to get the inflation protection) rather than another fixed instrument:
-
A specific need further
out than 10 years;
-
Investors
who are buying fixed investments for a longer time horizon than we recommend;
-
Investors
who are too nervous about being invested in the market and who do not have a need
for the money.
The
Bottom Line
Based
on individual situations, goals, needs, and your tax situation, you should compare
an after-tax return on several fixed-income securities and always check with your
tax adviser before purchasing. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
