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Awhile back, Tim explained to us the definition of inflation. In a nutshell, it’s a real force that reduces your purchasing power. In other words, your money doesn’t go as far. Think about the high gas prices, for instance.
Even though he explained one way to cure inflation, he didn’t get into how to make sure that your investments stay ahead of inflation.
There’s a simple way to outpace inflation, and that’s what I’m going to discuss in this post.
The easiest way to fight inflation is by investing in TIPS, which stand for Treasury Inflation-Protected Securities. These are U.S. government bonds that – get this – automatically go up in value when inflation rises.
With TIPS, your investment increases with inflation, and actually decreases with deflation. Adjustments to your principal investment are made according to changes in the Consumer Price Index. But the good thing is this:
Regardless of inflation or deflation, when your investment matures, you get your adjusted principal or original investment – whichever is greater.
You receive interest twice a year, at a fixed rate. This rate is applied to the adjusted principal. So just as your principal rises with inflation and falls with deflation, so do your interest payments.
With inflation, you get more interest. With deflation, you get less.
The other good thing about them is that they’re backed by the full faith and credit of the U.S. This is a fancy way of saying that you won’t lose your money or your interest payments.
Where to Buy TIPS
You can get them from the TreasuryDirect website through a bidding process.
Here are important things to know:
- TIPS are sold in maturities of 5, 10, and 30 years. Each term is auctioned at a different time of year.
- The price you pay and the interest rate you receive are determined at auction.
- The minimum purchase price is $100, but you can invest more in increments of $100.
Tax Issues For TIPS
Because you’ll receive interest payments and increases in your principal, both are subject to federal income tax. However, the good news is that they are exempt from state and local income taxes.
Your taxable income is reported on two forms:
- 1099-INT – this shows the interest payments you receive each year.
- 1099-OID – this shows how much your principal has increased due to inflation, or decreased because of deflation.
It’s important to know that increases in principal are taxable in the year they happen – even though your TIPS hasn’t matured and you haven’t received your return of principal.
And if you buy TIPS through the TreasuryDirect site, you can ease your tax burden by withholding up to 50% of your earned interest .
Because of these tax issues, TIPS are best suited for tax-deferred acounts such as an IRA or 401K, where they won’t increase your taxable income.
Now you know how TIPS guarantee that your money won’t be eroded by inflation. In one investment, you protect yourself from both financial loss, as well as loss of purchasing power.
Do you invest in TIPS?