Unknown to many investors, the United States Treasury offers an attractive alternative to conventional bonds: Treasury Inflation Protection Securities (TIPS). Although often overlooked by investors, not only can these inflation-indexed Treasury bonds outperform conventional non-indexed bonds when inflation is on the rise, they can be a good addition to your tax-deferred retirement portfolio.

Most investors are familiar with how traditional Treasury notes and bonds work: you lend the government money and the government promises to repay your investment plus interest. TIPS are a variation of these traditional securities. However, unlike other government securities, TIPS are indexed for inflation.

Here's how TIPS work: you lend the government money and in addition to promising to repay your investment plus interest, the government indexes your investment for inflation based upon the Consumer Price Index. Your investment will also be adjusted for deflation and even decreasing prices, should that relatively rare economic phenomenon occur.

You decide to invest $10,000 to purchase a 10-year TIPS bond. The rate of interest is four percent (4%). You will earn 4% interest over the 10-year life of the bond. If inflation rises to five percent, the value of your investment, initially $10,000, is now adjusted to $10,500. The upside? Instead of earning 4% interest on $10,000, you will earn 4% interest on $10,500. If inflation again rises, your value will again be recalculated. Your interest rate, because it is fixed, remains at 4% until the bond matures.

TIPS pay semi-annual interest and the rate of interest is fixed at the time of your purchase (this is called a fixed coupon rate). Because the value of the security rises or falls with increases or decreases in inflation, your semi-annual interest payments will vary. Interest will be distributed semi-annually until the bond matures. When the bond matures, you will receive the value of the bond adjusted for either inflation or deflation.

Although inflation-indexed securities are relatively new in the United States, other countries, such as the United Kingdom, Israel and Sweden, have sold them for years. Since their introduction in the U.S., the annual rate of inflation has been low and consumer prices fell from a 2.5 percent rate of inflation in 1997 to 1.9 percent in 1999. Although this may explain why TIPS are not as well known as other investments, someone has heard of them - currently, more than $80 billion TIPS are outstanding.

Historically, stocks give good protection from inflation. However, as we have seen recently, the stock market can experience short-term declines. While conventional bonds - bonds that are not indexed for inflation - are an important component of an investment mix, the performance of these bonds may lag when inflation rises and their purchasing power may also erode. In this scenario, holding some bonds that are inflation protected - such as TIPS - would offset lower returns from other securities.

Although earnings from TIPS are exempt from state and local taxation, federal tax is paid on all interest earnings and any inflation adjustments in the year you receive them. This means that you must report earnings and adjustments on your federal tax return in the year credited.

If you own a $10,000 TIPS and you earn $400 in interest over the course of one year, you will pay tax on that $400. In addition, if the bond’s value was adjusted for inflation, let’s say 3%, you also will pay tax on that adjustment of $300. Because you pay tax as the adjustments are made, you will not pay tax on the increased value of your initial investment when the bond matures.

One way to postpone the tax bite is to purchase these inflation-indexed securities for your Individual Retirement Account or other tax-deferred retirement accounts. Because you purchased the bonds for a tax-deferred account, you will not pay federal tax on your earnings and the adjustments until you start to receive distributions from the plan. It is for this reason that many investors believe that TIPS work best in a tax-deferred retirement account.

If you would like to receive additional information regarding how TIPS may benefit you, please contact the office for a consultation.