A second drawback for TIPS is that owners are taxed on annual increases in the principal value of a TIPS bond in the years before maturity even though the owner does not realize the benefit until the end of the bond's term. This is known as a tax on "phantom income" and means it is best to own TIPS inside an IRA or another kind of tax-deferred account. That will allow the owner to shield this phantom income from taxation until the funds are withdrawn from the IRA or other tax-deferred account.
It also should be noted that TIPS differ in several ways from I-series U.S. Savings Bonds, which also adjust for inflation but in a different manner. I Bonds include a fixed earnings rate that remains the same, plus a variable that changes with inflation.
Other differences include the following: I Bonds are non-marketable, meaning they can't be bought or sold through a broker; I Bonds purchases are limited to $5,000 per year per person; and I Bonds interest accrues over the life of the bond and is paid upon redemption, rather than twice a year.
Finally, many individual investors may want to own TIPS through a mutual fund or exchange-traded fund that invests in TIPS. Examples include the Vanguard Inflation-Protected Securities Fund, American Beacon TIPS Fund, Fidelity Inflation-Protected Bond Fund, iShares Barclay TIPS Exchange-Traded Fund and SPDR Barclays Capital TIPS ETF.
A TIPS fund allows the investor to own a wide mix of TIPS of varying maturities and create a more diversified portfolio. Also, a TIPS fund avoids the phantom income tax problem. However, as with any bond fund, the investor in TIPS mutual fund or ETF is not guaranteed a return of principal as they may need to sell the fund at a time when its value is down due to market conditions.
But whether owned directly or through a fund, TIPS can be a sound way to help to stay a step ahead of inflation and a possible return to the 1970s.
This work is the opinion of the columnist and in no way reflects the opinion of ABC News.
David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at email@example.com.