Treasury Inflation-Protected Securities, or TIPS, are Treasury securities whose principal is indexed to the Consumer Price Index (CPI) in order to guard against inflation.
Learn how TIPS work through an example, along with how to invest in and pay taxes on them.
What Are Treasury Inflation-Protected Securities?
TIPS are fixed-income securities with a principal amount that adjusts according to changes in the CPI, a measure of changes over time in the price of a basket of consumer goods. Specifically, the principal rises with inflation and falls with deflation. As such, TIPS provide protection against inflation.
- Acronym: TIPS
How Treasury Inflation-Protected Securities Work
As fixed-income securities, TIPS are in the same investment family as conventional bonds but function in a distinct way. Importantly, a conventional fixed-rate bond makes coupon payments on the par (face) value (for example, 5% annual interest on $1,000), and the par value is returned upon maturity of the bond. TIPS, in contrast, have the following characteristics:
- They're available with maturities of 5, 10, and 30 years.
- The principal of the security increases or decreases with the CPI.
- Interest payments are a fixed percentage of an increasing or decreasing principal.
- Principal adjustments and interest payments are made twice a year.
- The adjusted principal or the original principal, whichever is greater, is paid to the investor upon maturity (if bought at par value at the initial offering or auction).
To understand how TIPS function, it helps to look at an example of a TIPS investment from beginning to end. For the sake of simplicity, the example uses a bond purchased at a U.S. Treasury auction, at par value, and with a steadily increasing CPI.
- An investor goes to TreasuryDirect.gov and buys a five-year, $10,000 Treasury Inflation-Protected Security at auction with a 1.00% coupon rate (the interest rate on the bond).
- The CPI rises by 3% annually (a semi-annual rate of 1.5%).
- As a result of the CPI, the principal amount of the bond is increased by 1.5% after six months, making the adjusted principal $10,150.
- A coupon payment of $50.75 (50% of the 1.00% coupon rate multiplied by the adjusted principal of $10,150) is made to the investor.
- At the end of calendar year one, the investor is taxed on the coupon payments and the adjustments to the principal. This taxation is continued throughout the life of the bond.
- The investor continues to receive the coupon rate multiplied by the adjusted principal on a semi-annual basis (in this case, the adjusted principal is increased by 1.5% every six months).
- At maturity, five years from the date of the auction, the investor receives the adjusted principal of $11,605.41 and the final coupon payment of $58.03 (50% of 1.00% multiplied by $11,605.41).
Amidst deflation, an investor may receive a lower interest payment in one period than in a prior period, but upon maturity of the TIPS, they will never receive less than the original principal.
What Are the Penalties?
Interest income and growth of the principal for Treasury Inflation-Protected Securities are taxed as income at the federal level; however, neither income nor growth is taxed at the local or state level.
In fact, increases in the principal are referred to as "phantom income" because they're taxable in the year you incur them regardless of whether the security has matured and you have received the principal.
TIPS investors will receive a Form 1099-OID for the phantom income and a Form 1099-INT for the interest payments (if the TIPS are held in a taxable account).
Hold TIPS in a tax-deferred retirement account (an IRA, for example) to avoid taxation.
How to Get Treasury Inflation-Protected Securities
TIPS can be purchased from the U.S. Treasury through TreasuryDirect.gov. The website provides a Tentative Auction Schedule that provides the dates of upcoming TIPS auctions. Investors can also buy TIPS on the secondary market through a bank or brokerage firm.
Alternatively, you can buy mutual funds that own TIPS to enjoy the advantages of mutual funds. The Vanguard Inflation-Protected Securities Fund (VIPSX) and Harbor Real Return Fund (HARRX) are a few examples of TIPS mutual funds.
- Treasury Inflation-Protected Securities have a principal that is indexed to the CPI to protect against inflation.
- TIPS are bond-like investments, but interest is paid twice a year based on a principal amount that is adjusted for inflation semiannually.
- Interest income and the growth of the principal for TIPS are taxable at the federal level but not the state or local level.
- Investors can either directly purchase individual TIPS from the U.S. Treasury or indirectly holding TIPS through a mutual fund.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.