Inflation Alert: Consider Investing in TIPS

The Fed is finally taking aggressive action to fight inflation, but will it work?

Where’s the stock market headed?

Who knows?

Real estate might be a good inflation hedge, but it’s a non-liquid asset and no sure thing.

Clearly, this is not a great environment for investors or retirement savers.

If you are thinking of investing conservatively but in a way that also offers some inflation protection, here’s an option to consider.

Treasury Inflation-Protected Securities

U.S. Treasury Inflation-Protected Securities (TIPS) are a special variety of Treasury bonds that are adjusted for inflation.

Specifically, in times of inflation, TIPS principal balances are adjusted upward twice a year, based on changes in the Consumer Price Index.

In contrast, significant inflation can punish the conservative investment strategy.

Okay, sounds interesting. How do TIPS work?

TIPS Basics

TIPS are sold at original issuance with terms to maturity of five, 10, and 30 years. They pay cash interest twice a year at a fixed rate that’s set at issuance.

Also, as we mentioned above, during times of inflation, TIPS principal balances are adjusted upward twice a year.

You receive the following if you hold a TIPS bond:

  1. Cash interest payments twice a year at the stated fixed rate. Each semiannual payment equals half the stated rate times the inflation-adjusted principal balance at the time of the payment. So, cash interest payments go up with inflation because they are based on the increasing inflation-adjusted principal balance.
  2. At the date of maturity, you receive the inflation-adjusted principal balance.

    Example 1. Simplest Case

    On July 15, 2022, you invest $200,000 in an original-issue, five-year TIPS bond with a face value of $200,000 that pays a fixed annual interest rate of 0.5 percent. If inflation over the next six months is 7 percent, the inflation-adjusted principal balance is increased to $207,000 ($200,000 x (7 percent ÷ 2)), and you will receive a $518 interest payment in cash for that six-month period ($207,000 x 0.5 percent x 0.5 = $518).

    If the inflation rate for the following six months is 6 percent, the inflation-adjusted principal balance is increased to $213,210 ($207,000 x 1.03), and you will receive a $533 cash interest payment for that six-month period ($213,210 x 0.5 percent x 0.5).

    If inflation then runs at exactly 4 percent for every six-month period for the following four years, your interest payments will increase based on the inflation-adjusted principal balance for each six-month period. You will receive $249,809 at maturity on July 15, 2027 ($213,210 x 1.02 to the eighth power = $249,809).

     

    Reality Check

    As this was written, TIPS bonds maturing on July 15, 2027 (five years and two weeks later) that pay a fixed annual interest rate of 0.375 percent were trading at 99.554 in the secondary market. The inflation-adjusted principal balance factor for these bonds was 1181.1 Therefore, the price for one of these bonds with a par value of $100,000 was $117,573 ($99,554 x 1.181).

    If there’s significant inflation, the twice-yearly interest payments will increase as the inflation-adjusted principal balance goes up. But the interest payments still won’t amount to much because the fixed annual rate is so low (0.375 percent).

    If there’s significant inflation, the real money is earned from the fact that the principal balance will be adjusted for inflation. If you hold the bond to maturity, you’ll collect the twice-yearly inflation-adjusted cash interest payments plus the inflation-adjusted accrued principal balance as of July 15, 2027. If you sell before maturity in the secondary market, you’ll get what you get.  No guarantees.

      Example 2. Real-World Case 

      On July 1, 2022, you pay $117,600 in the secondary market to buy a TIPS bond with a face value of $100,000, an inflation-adjusted principal factor of 1.181, and a fixed annual interest rate of 0.375 percent. The bond matures on July 15, 2027.

      If you hold the TIPS bond to maturity and inflation runs at about 5 percent during your ownership period, you’ll recover your $117,600 investment plus about 5.375 percent annual interest (the fixed 0.375 percent annual rate plus 5 percent for inflation). As this was written, the nominal yield (ignoring inflation) on a regular $100,000 10-year Treasury bond purchased in the secondary market and held to maturity was about 3.04 percent.

      In rough numbers, you would need annual inflation to exceed about 2.715 percent (3.09 percent – 0.375 percent) for your TIPS investment to match the 3.09 percent yield on the regular 10-year Treasury bond.

      If inflation averages about 5 percent during your ownership period of five years and two weeks (July 1, 2022–July 15, 2027) for the TIPS bond maturing on July 15, 2027, you would come out well ahead. At the end of the day, you would collect roughly $152,800 from your $117,600 investment based on an annual return of about 5.375 percent for five years (ignoring the two weeks).2  

      Obviously, 5.375 percent is better than 3.09 percent. But the 3.09 percent is a sure thing if you hold the regular bond to maturity, while the 5.375 percent on the TIPS bond is just a guess.

      Bottom line. TIPS have a significant advantage over regular Treasuries if there’s significant and persistent inflation. Otherwise, not so much.

       

      The Deflation Scenario

      While deflation might seem highly unlikely at the moment, nothing is certain these days. Right?

      During periods of deflation, TIPS principal balances are adjusted downward twice a year. The twice-yearly interest payments are also adjusted downward—because they are based on a declining adjusted principal balance. The stated fixed interest rate itself doesn’t change.

      But even in the worst-case scenario of significant deflation during your ownership period, the results of owning a TIPS bond won’t be catastrophically bad, as long as you hold the bond to maturity. That’s because you’re guaranteed to receive at least the face value of the bond at maturity, even if the adjusted principal balance has fallen below that number.  If the inflation-adjusted principal balance exceeds the face value, you’ll receive the larger inflation-adjusted number.

      So, in Example 2, you would collect at least $100,000 when your TIPS bond matures on July 15, 2027—even if there’s significant deflation during your ownership period of five years and two weeks. This is certainly not a good result, because you paid $117,600 for the bond and only earned minimal interest while you owned it.

       Ways to Invest in TIPS

      The minimum face value for a TIPS bond is $1,000. Larger denominations are available in $1,000 increments.

      Original Issue

      You can purchase TIPS upon original issue directly from the government, through the online TreasuryDirect program.3

      The TreasuryDirect option is available only for TIPS purchased for taxable accounts. You cannot use a tax-favored retirement account, such as an IRA, to buy TIPS upon original issue via TreasuryDirect.

      If you buy a newly issued TIPS bond via TreasuryDirect, you’ll receive at least the face value of the bond if you hold it to maturity, even if there’s significant deflation.4  In other words, if you buy $100,000 of bonds via TreasuryDirect and hold them to maturity, then you receive no less than $100,000. 

      Secondary Market

      TIPS are marketable securities, so you can buy previously issued TIPS bonds in the secondary market through your friendly neighborhood brokerage firm.

      If you buy older TIPS in the secondary market and pay for the inflation adjustment to the principal balance, as illustrated in Example 2, that adjustment can vaporize with deflation. The way to avoid this risk is to buy TIPS at original issue or on the secondary market shortly thereafter.

      Warning. As with other Treasuries, secondary market prices for TIPS bonds fluctuate due to changes in prevailing interest rates, supply and demand, and other factors.

      Other things being equal, however, the following are true:

      • The secondary market price of TIPS will go down when the yield on regular Treasuries goes up, because that reduces the inflation-protection advantage of TIPS.
      • The secondary market price of TIPS will go up when the yield on regular Treasuries goes down, because that increases the inflation-protection advantage of TIPS.

      If you don’t intend to hold your TIPS to maturity, please understand that market prices can and do change on a daily basis. And there’s no certainty about how much you can sell your TIPS for in the secondary market.  You’ll get what you get.   May the force be with you.

      TIPS ETFs

      A simpler alternative to direct ownership of TIPS is buying shares in an exchange traded fund (ETF) that invests in a basket of TIPS bonds that simulate the results from direct investments in TIPS.

      You can hold TIPS ETFs in a tax-advantaged retirement account or in a taxable brokerage firm account. TIPS ETFs usually pay monthly distributions. But distributions may be skipped in times of deflation.

      • Broad-spectrum TIPS ETFs include the iShares TIPS Bond ETF (TIP on the NYSE), the Schwab U.S. TIPS ETF (SCHP), and the PIMCO Broad US TIPS Index ETF (TIPZ)
      • One medium-term maturity TIPS ETF is the SPDR Bloomberg Barclays 1-10 Year TIPS ETF (TIPX on the NYSE).
      • Shorter-term maturity TIPS ETFs include Vanguard Short-Term Inflation-Protected Securities ETF (VTIP on the Nasdaq) and the iShares 0-5 Year TIPS Bond ETF (STIP on the NYSE).
      • The total return from holding a TIPS ETF depends on the distributions that you receive (usually monthly) and on share price appreciation or depreciation. As investors have discovered this year, share prices can go down or up depending on bond market changes. Significant downward moves have occurred this year.
      • Share prices of ETFs that hold longer-term TIPS are more volatile than those that hold shorter-term TIPS.

      Key point.  We are not endorsing any of these ETFs. They are mentioned for information purposes only.

      As examples of the recent performance of a couple of TIPS ETFs, SCHP had a YTD total return of -8.26 percent as this was written. VTIP had a YTD return of -1.12 percent. Ugh, so far.5

      But SCHP had a total return of 5.86 percent in 2021, 10.94 percent in 2020, and 8.36 percent in 2019. VTIP had a return of 5.32 percent in 2021, 4.97 percent in 2020, and 4.83 percent in 2019.6

      TIPS Tax Considerations

      Cash interest payments from TIPS and non-cash increases in the principal of TIPS are subject to federal tax at ordinary income rates, but exempt from state and local income taxes.

      TreasuryDirect and the brokerage houses report the TIPS amounts subject to the federal income tax on two information forms:7

      • Form 1099-INT shows the sum of the semiannual cash interest payments made to you in a given year.
      • Form 1099-OID shows the amount by which your TIPS principal amount increased or decreased due to inflation.

      Negative Adjustment

      Remember, if deflation occurs, the Treasury Department adjusts the principal balance of the TIPS bond downward (but not below the original issue price).

      For tax purposes, a negative principal balance adjustment first reduces taxable interest income from cash interest payments received in the year of the adjustment. If the negative adjustment exceeds the cash interest payments, you can generally claim the loss to the extent there was previous taxable interest income from cash interest payments. Any remaining negative adjustment is carried forward to reduce taxable income from cash interest payments in future years.8

      TIPS ETF

      When you hold a TIPS ETF in a taxable account, the distributions that you receive (usually monthly) are generally high-taxed ordinary income.

      But some distributions may include lower-taxed long-term capital gains. If you sell a TIPS ETF for a gain or loss, it’s a short-term or long-term capital gain or loss, depending on how long you held the shares.9 

      Tax Planning Consideration

      When you hold a TIPS investment with TreasuryDirect or in a taxable brokerage firm account, the cash interest payments and any positive inflation adjustments to the principal balance will be high-taxed ordinary income—even though the inflation adjustments are currently not paid in cash.

      Paying current taxes on the inflation adjustments is not good, because you won’t actually collect the cash until the TIPS matures or you sell it in the secondary market. In other words, you have to pay taxes on “phantom income.”

      You can avoid that problem by holding direct TIPS investments acquired in the secondary market in a tax-advantaged retirement account.

      Key point. None of this tax stuff matters for TIPS held in a tax-favored retirement account—such as a traditional or Roth IRA, 401(k), or SEP.

      Inside the retirement account, the TIPS money you make or lose affects the retirement account balance. On traditional accounts, you pay taxes at ordinary rates when you take withdrawals.

      Of course, qualified Roth IRA withdrawals are federal-income-tax-free.

      Takeaways

      Investing in original-issue TIPS at TreasuryDirect instead of “safe” garden-variety fixed income instruments will pay off if there’s significant inflation and you hold to maturity.

      Ditto if you buy TIPS in the secondary market and hold to maturity.

      If you sell before maturity, you face the whims of the Treasury bond market and results can vary. For instance, the price of TIPS can drop if the yields on regular Treasuries go up. 

      If you buy a TIPS ETF, you are also subject to the whims of the Treasury bond market. So far this year, the results from holding TIPS ETFs have not been good.

      There’s one tax disadvantage to TIPS investments: you are taxed on phantom income. But holding direct TIPS investments acquired in the secondary market in a tax-favored retirement account avoids the phantom-income tax problem.

      In the current investment environment (as with most such environments), there are no sure things. TIPS are no exception, despite the currently raging inflation.

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      IRS Section 199A Final Regs Shed New Light on Service Businesses Remember, new tax code Section 199A offers you a 20 percent tax deduction gift if you havepass-through business income (such as from a proprietorship, a partnership, or an S corporation), and2018 taxable...

      IRS Updates Defined Wages for New Section 199A Tax Deductions

      IRS Clarifies Net Capital Gains in Final 199A Regulations Your Section 199A tax deduction will benefit from your business’s W-2 wages paid to you and your employees if you are married and filing jointly and your taxable income is over $315,000 and less than...

      Good News: Most Rentals Likely Qualify as Section 199A Businesses

      Good News: Most Rentals Likely Qualify as Section 199A Businesses The Tax Cuts and Jobs Act tax reform added new tax code Section 199A, which created a 20 percent tax deduction possibility for you if your rental property (a) has profits and (b) can qualify as a trade...

      How to Reimburse Medicare When You Have Fewer Than 20 Employees

      How to Reimburse Medicare When You Have Fewer Than 20 Employees The Affordable Care Act’s $100-a-day penalty for improper medical reimbursements likely has your attention. And it should. But you can find many reimbursements that are allowed without penalty, including...

      What Can I Do If My K-1 Omits 199A Information?

      What Can I Do If My K-1 Omits 199A Information? Tax reform’s Section 199A deduction often confuses small-business owners and tax professionals alike. It’s quite possible you’ll get a Schedule K-1 from a business that omits the information you need to calculate your...

      Terminating Your S Corporation Election

      Terminating Your S Corporation ElectionTax reform may have you thinking of changing your S corporation to a C corporation, partnership, or sole proprietorship. With such a switch, you need to consider: How do I terminate the S corporation election correctly? What are...

      When the Second Office in the Home Is a Principal Place of Business

      When the Second Office in the Home Is a Principal Place of Business When possible, you want to claim that your office in your home qualifies as a principal place of business because this classification gives you the home-office deduction, and eliminates commuting from...

      Backdoor Roth IRA Opportunities Still Available After TCJA

      TCJA Tax Reform Sticks It to Business Start-Ups That Lose Money Good news. The Tax Cuts and Jobs Act (TCJA) didnot harm the backdoor Roth strategy. As you likely know, the Roth IRA is a terrific wayto grow your wealth with a minimum tax downsidebecause you pay the...

      Combine Home Sale with the 1031 Exchange

      Combine Home Sale with the 1031 ExchangeYou don’t often get the opportunity to even consider making a tax-saving double play. But your personal residence combined with a desire for a rental property can provide just such an opportunity.  The tax-saving strategy is to...

      Know These Tax Rules If Your Average Rental Is Seven Days or Less

      If you own a condominium, cottage, cabin, lake or beach home, ski lodge, or similar property that you rent for an “average” rental period of seven days or less for the year, you have a property with unique tax attributes.

      Avoid This S Corporation Health Insurance Deduction Mistake

      If you own more than 2 percent of an S corporation, you have to do three things to claim a deduction for your health insurance:
      You Must…

      QBI Issue When Your S Corp Is a Partner in a Partnership

      It’s common to consider making your S corporation (versus yourself) a partner in your partnership: it saves you self-employment taxes.

      Does this affect your Section 199A deduction? It does.

      Can the IRS Require Odometer Readings with the Mileage Rate?

      Do you claim your business miles at the IRS optional rate? If so, imagine you are now being audited by the IRS for your business mileage. The IRS has requested odometer readings for your vehicle. You might wonder if the IRS can do this…

      New Individual Coverage HRA Allows You to Reimburse Employees for Health Insurance

      New Individual Coverage HRA Allows You to Reimburse Employees for Health InsuranceThe new Individual Coverage HRA (ICHRA) lets you help employees with their health care costs without fear of ACA penalties. Starting January 1, 2020, employers can offer this new ICHRA....

      How to Deduct Assisted Living and Nursing Home Bills

      How to Deduct Assisted Living and Nursing Home Bills” Watch your wallet: the median cost in 2018 for an assisted living facility was $48,000 and over $100,000 for nursing home care. If you could deduct these expenses, you’d substantially reduce your income tax...

      Tax Issues of Converting Your Residence into a Rental Property

      Tax Issues of Converting Your Residence into a Rental Property The simple maneuver of converting your personal residence to a rental property brings with it many tax rules, mostly good when you know how they work. The first question that arises when you convert a...

      Congress Reinstates Expired Tax Provisions

      The big five tax breaks that most likely impact your
      Form 1040

      Eight Changes in the SECURE Act You Need to Know

      Eight Changes in the SECURE Act You Need to Know As has become usual practice, Congress passed some meaningful tax legislation as it recessed for the holidays. In one of the new meaningful laws, enacted on December 20, you will find the Setting Every Community Up for...

      Kiddie Tax Changes

      On December 19, 2019, Congress passed a bill that the president signed into law on December 20, 2019 (Pub. L. 116-94). The new law repeals the kiddie tax changes from the TCJA and takes you back to the old kiddie tax rules, even retroactively if you so desire.

      Solo 401(k) Could Be Your Best Retirement Plan Option

      Solo 401(k) Could Be YourBest Retirement Plan Option Have you procrastinated about setting up a tax-advantaged retirement plan for your small business? If the answer is yes, you are not alone. Still, this is not a good situation. You are paying income taxes that could...

      Use Your Business to Maximize Charitable Donations

      …for the purposes of tax savings, some forms of giving are much more beneficial to you than are others

      Avoid the Gift Tax—Use the Tuition and Medical Strategy

      If you or a well-off relative are facing the gift and estate tax, here’s a planning opportunity often overlooked: pay tuition and medical expenses for loved ones. Such payments, structured correctly, do not represent gifts.

      What are My Self-Employed Tax Obligations?

      What are My Self-Employed Tax Obligations? As a self-employed individual, generally you are required to file an annual return and pay estimated tax quarterly. Self-employed individuals generally must pay self-employment tax (SE tax) as well as income tax. SE tax is a...

      Q&A: PPP Forgiveness Answers for S Corporation Owner-Employees

      Q&A: PPP Forgiveness Answers for S Corporation Owner-Employees  Tax law definitions do not apply to much of the PPP, making it new ground for owners of S corporations. Here are answers to four questions of concern to many S corporation owners. 1. Spouse Owns S...

      Five things to know about employing your spouse.

      Five things to know about employee in your spouse1. Pay Your Spouse Tax-Free Employee Benefits, Not Taxable Wages   You’ll realize no tax savings if you put your spouse on the payroll and pay him or her cash wages.  Employee wages you pay your spouse are fully...

      New Stimulus Law Grants Eight Tax Breaks for 1040 Filers

      New Stimulus Law Grants Eight Tax Breaks for 1040 Filers  The new, massive stimulus bill enacted into law on December 27, 2020, contains eight new tax breaks designed to help the non-business taxpayer. None of these tax breaks are earthshaking by themselves, but...

      2020 Year-End Tax Strategies for Marriage, Kids, and Family

      2020 Last-Minute Year-End Tax Strategies for Marriage, Kids, and FamilyIf you have children under the age of 18 and you file your business tax return as a proprietorship or partnership, you can find big savings in the work your children do for your business. And if...

      Remember to consider your Section 199A deduction in your year-end tax planning.

      Remember to consider your Section 199A deduction in your year-end tax planning.Remember to consider your Section 199A deduction in your year-end tax planning. If you don’t, you could end up with a big fat $0 for your deduction amount. We’ll review three year-end moves...

      Starting a New Business? Get Up to $100,000 in Tax-Free Money

      Starting a New Business? Get Up to $100,000 in Tax-Free MoneyYou likely already know that the employee retention credit (ERC) is a good deal—if you qualify.  Now, thanks to the recently enacted American Rescue Plan Act of 2021 (ARPA), you can qualify for up to...

      Tax Code Offset Game

      2020 Last-Minute Year-End Tax Strategies for Tax Code OffsetWhen you take advantage of the tax code’s offset game, your stock market portfolio can represent a little gold mine of opportunities to reduce your 2020 income taxes.  The tax code contains the basic rules...

      “Deduct 100 Percent of Your Business Meals under New Rules”

      Deduct 100 Percent of Your Business Meals under New RulesNow, thanks to a new law enacted December 27, 2020, new IRS regulations, and a new IRS notice (yep, all three are new), you have fresh opportunities for writing off 100 percent of your business meals. For 2021...

      Year End Medical Plan Strategies

      Here are the six opportunities for you to consider for your business’s Year End Medical Plan Strategies.

      Last Minute 2020 Biz Deductions

      The purpose of this post is to get the IRS to owe you money.

      Of course, the IRS is not likely to cut you a check for this money (although in the right circumstances, that will happen), but you’ll realize the cash when you pay less in taxes.
      Here are seven powerful business tax deduction strategies that you can easily understand and implement before the end of 2020.

      Last Minute Year End Deductions for Married or Divorced people – Tax Strategies – Kiddie Tax

      Last Minute Year End Deductions for Married or Divorced people – Tax Strategies – Kiddie Tax –
      If you are thinking of getting married or divorced, you need to consider December 31, 2020, in your tax planning.

      Here’s another planning question: Do you give money to family or friends (other than your children, who are subject to the kiddie tax)? If so, you need to consider the zero-taxes planning strategy.
      #taxplanning #CPA #businessaccountant

      2021 Last Min – Year End Retirement Deductions

      2021 Last-Minute Year-End Retirement Deductions
      The clock continues to tick. Your retirement is one year closer.
      You have time before December 31 to take steps that will help you fund the retirement you desire.
      Take a few minutes to review the four retirement plan tax-reduction strategies in this article.
      You might find several thousand dollars (and maybe much more) in your pocket by taking the actions in this article. But you’ll need to act now to get the cash.

      Do you need more 2020 tax deductions?

      Do you need more 2020 tax deductions?

      Tax Implications of Investing in Precious Metal Assets

      These days, some IRA owners and investors may be worried about being overexposed to equities. That could be you.
      But the safest fixed income investments (CDs, Treasuries, and money-market funds) are still paying microscopic interest rates.
      For example, when this was written, the 10-year Treasury was yielding about 1.92 percent. Ugh!
      Meanwhile, the pandemic might or might not be coming to an end, the economy might or might not be okay, and inflation might or might not be controlled. Who knows?
      In this uncertain environment, investing some of your IRA money in gold or other precious metals such as silver and platinum may be worth considering. Ditto for holding some precious metal assets in taxable form. This article explains the federal income tax implications. Here goes.

      Health Savings Accounts: The Ultimate Retirement Account

      Health Savings Accounts: The Ultimate Retirement Account Looking to save for retirement? The first account you should open and fund is not an IRA (regular or Roth) or 401(k). If you qualify, your first retirement account should be a Health Savings Account (HSA). Don’t...
      Want to know more?  Have some tax questions of your own?  Get in touch with us and we’ll guide you thru the tax and accounting process.

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      Using Children’s IRAs to Pay for College

      Using Children’s IRAs to Pay for College If your child has earned income (maybe from working in your business), you may want to consider establishing an IRA for your child. The IRA funds can, in turn, be used to help pay your child’s college expenses. When your child...

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      Clean Vehicle Credits

      Clean vehicle credits can help car buyers pay less at the dealership RS Tax Tip 2023-123, Nov. 15, 2023 Taxpayers who buy a qualifying new or used clean vehicle may be able to transfer their tax credits to the dealer in exchange for a financial benefit – such as a...

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      NFT’s and Taxes

      NFT's & Taxes Did you buy, sell, donate, or receive an NFT during the tax year? If so, you must answer “yes” to the digital assets question on page one of the IRS Form 1040. Additionally, if you have sold an NFT, you could be liable for tax or eligible for a...

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      Home Office Deduction

      Home Office DeductionWith a growing number of business owners now working from home, many may qualify for the home office deduction, also known as the deduction for business use of a home. Usually, a business owner must use a room or other identifiable portion of the...

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      Cryptocurrency

      Digital assets include (but are not limited to): Convertible virtual currency and cryptocurrency Stablecoins Non-fungible tokens (NFTs) Digital assets are broadly defined as any digital representation of value which is recorded on a cryptographically secured...

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