TIPS vs. I Bonds: Which Offers Better Inflation Protection in 2023?

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tips vs. i bonds

Inflation has become a household concept lately. As a result, two under-the-radar financial products have found themselves in the limelight: TIPS and I Bonds. Knowing when to buy TIPS vs. I Bonds will help you construct your inflation protection portfolio appropriately.

Series I Savings Bonds (I Bonds), issued by the U.S. Treasury, have been recently highlighted by the media, savers, and investors as a way to earn a yield that keeps pace or even surpasses the rate of inflation. At the same time, the Treasury Inflation-Protected Securities (TIPS) have also seen a surge in popularity. TIPS are designed to offer enhanced yields as consumer prices increase, potentially offering investors a more substantial edge compared to I Bonds, especially during inflationary tides.

Why you should care:

  • Both TIPS and I Bonds are bonds issued by the U.S. government that aim to protect savers and investors from inflation. While both have the same purpose, they accomplish this differently.

What you should know:

  • Many investors buy both TIPS and I Bonds to protect themselves from inflation.
  • I Bonds have an annual electronic purchase limit of $10,000. Additionally, you can buy up to $5,000 in paper I Bonds using your federal tax refund, making the total limit $15,000 per year. For most investors, TIPS effectively do not have a purchase limit ($5 million per individual per auction).
  • I Bonds can only be bought and redeemed from TreasuryDirect. TIPS can be bought on TreasuryDirect in addition to brokerages. They can also be purchased through TIPS ETFs.

Understanding Inflation and Why It Matters

Inflation refers to the general rise in prices of goods and services over time. For instance, if a meal at your favorite diner costs $10 today, with a 3% annual inflation rate, the same meal will cost you $10.30 next year. Over time, this adds up and can significantly affect your purchasing power.

Now, let’s delve into bonds, which have become more popular as an investment with interest rates going up. When you buy a bond, you’re lending money to an entity, like a government or a company, with the promise that they’ll pay you back with some interest over time. Bonds usually have fixed interest payments, which means you get a set amount of money periodically.

However, inflation can be a spoiler here. As prices rise, the purchasing power of the fixed interest you receive decreases. It’s like getting a smaller slice of the pie while the pie itself stays the same size.

Recognizing this, the U.S. Treasury developed two types of bonds.

The first type is called Treasury Inflation-Protected Securities (TIPS), introduced in 1997. With TIPS, both the principal amount and the interest payments rise when inflation does. The second type of bond is Series I Savings Bonds, introduced in 1998. I Bonds have interest rates that are adjusted twice a year to reflect the changes in the Consumer Price Index (CPI), a popular measure of inflation. The returns from Series I Savings Bonds stay in step with inflation.

What Are Treasury Inflation-Protected Securities (TIPS)?

TIPS are a U.S. Treasury bond designed to help investors protect against inflation.

Every six months, the principal value of TIPS adjusts with inflation, as measured by the Consumer Price Index. Your interest payments increase as inflation increases. 

When TIPS matures, the investor receives either the adjusted principal or the original principal, whichever is higher.

What Are Series I Savings Bonds (I Bonds)?

I Bonds are a type of savings bond that pays interest every six months based on a composite rate. This composite rate is calculated using a fixed interest rate (set by the U.S. government when you buy the bond) and a variable inflation rate. The variable inflation rate is adjusted twice a year and indexed against the Consumer Price Index (CPI). I Bonds can be purchased either electronically through TreasuryDirect or in paper form through your federal tax returns.

I Bonds can earn interest for up to 30 years. You can’t cash them out in the first 12 months, and you’ll give up three months’ interest if you cash out your I Bonds before five years.

How Do TIPS and I Bond Adjust to Inflation?

Let’s delve into how they adjust to inflation using simple examples, assuming an investment of $1,000 in both TIPS vs. I Bonds, and an annual inflation rate of 2%.

TIPS adjust the principal amount based on inflation or deflation, as measured by the Consumer Price Index (CPI). In our example, with a 2% inflation rate, the principal amount of TIPS would increase to $1,020 ($1,000 * 1.02) after a year. Suppose TIPS had a fixed interest rate of 1%. The interest payment for the year would be $10.20 ($1,020 * 0.01). If inflation continues at the same rate, the principal will keep adjusting upward, and so will the interest payments.

I Bonds have a combined rate comprising a fixed rate and a semiannual inflation rate. The composite rate is calculated through a more complex formula involving these two components. Suppose the fixed rate is 0.5% and the inflation rate is 2%. The interest for the first year on your $1,000 investment would be calculated based on this composite rate of 2.5%. Unlike TIPS, the principal amount remains the same. What changes is the rate at which you earn interest.

Key Differences Between TIPS vs. I Bonds

There are three key differences between TIPS vs. I Bonds.

The first is the purchase limit. With TIPS, you can buy up to $5 million worth of TIPS at auction and an unlimited amount in the secondary market such as your brokerage firm. I Bonds, on the other hand, have an annual purchase limit of $15,000 — $10,000 in electronic bonds and $5,000 in paper bonds through your federal tax refund.

Second, TIPS can be bought in 5, 10, and 30-year maturities. I Bonds are only sold in 30-year terms. You can resell TIPS on the secondary market, while I Bonds cannot be resold. However, I Bonds can be redeemed after 12 months, although there is a penalty if you redeem before the 5-year mark.

Finally, I Bonds and TIPS have different tax treatments. The interest accrued on I Bonds can be deferred for federal income tax until they are redeemed or until they stop earning interest after 30 years. The major disadvantage of TIPS is that there is a tax on the income payments as well as the inflation adjustment made to the principal. Therefore, we suggest buying TIPS in a tax-sheltered account such as your IRA or 401(k). Both are exempt from state and local taxes.

Here’s a table that goes over the features of each:

Features TIPS I Bonds
Type of Investment Marketable—can be bought and sold in the secondary securities market Non-marketable—cannot be bought or sold in the secondary securities market. Registered in names of individuals and some entities.
Issuer US Government US Government
Inflation Protection Hedge Against Inflation Hedge Against Inflation
Inflation Measurement CPI-U Consumer Price Index CPI-U Consumer Price Index
Online Purchase Available on Treasurydirect.gov, Marketable Available for Online Purchase
Tax Treatment Subject to Federal Taxes Only Exempt From Local and State Taxes
Purchase Method At auction through TreasuryDirect, or through banks, brokers, and dealers Through Treasurydirect.gov, Non-Marketable
Minimum Holding Period 45 Days (If Bought as ETF), No Minimum Holding Period 12 Months, With Early Redemption Penalty
Purchase Limits $5 Million per Individual/Household per Auction $10,000 Annually per SSN or Tax ID Number
Terms/Maturities Issued in 5, 10, and 30-Year Terms Available for 30-Year Term
Inflation Adjustment Method Adjusted via Principal Amount Adjusted via Interest Rate
Method of Taxation Interest Payments Subject to Annual Federal Tax Interest Payments Taxed at Redemption Rate
Interest Floor Government's Promise of No Negative Yield Never Goes Below Zero
Return of Principal Price Depends on Secondary Market for Early Sale Always Get Original Principal Back

How to Choose Between TIPS vs. I Bonds

Both I Bonds and TIPS are backed by the full faith and credit of the U.S. government. Whichever you choose to buy, you know you’ll earn your principal back if you hold to maturity. I Bonds are one of the best ways to earn yields that adjust with inflation, but the purchase limit can be low for some investors, in which case TIPS offer a different type of inflation protection in a more meaningful way.

FAQ

What are TIPS and I Bonds?

TIPS, or Treasury Inflation-Protected Securities, and I Bonds, or Series I Savings Bonds, are both types of bonds issued by the U.S. Treasury that offer investors protection against inflation.

How do TIPS and I Bonds offer inflation protection?

TIPS adjust their principal value and I Bonds adjust their interest rates in response to inflation, by tracking changes in the Consumer Price Index (CPI).

What is the difference between TIPS vs. I Bonds?

TIPS are inflation-protected bonds with a fixed interest rate, while I Bonds have a variable interest rate that is adjusted for inflation.

Can I buy TIPS and I Bonds?

Yes, you can buy both TIPS and I Bonds. TIPS can be purchased through TreasuryDirect or your brokerage, while I Bonds can be purchased either electronically through TreasuryDirect or in paper form on your federal tax returns.

Are TIPS and I Bonds subject to federal income tax?

Yes, both TIPS and I Bonds are subject to federal income tax. However, both are exempt from state and local taxes.

What happens if I redeem my TIPS or I Bonds before they mature?

If you redeem your TIPS, you will receive the current value of the bond, which may be more or less than the face value depending on changes in inflation and interest rates.

If you redeem your I Bonds in the first 5 years, you receive your original principal back but pay a penalty of 3 months’ interest. 

Can I buy individual TIPS or I Bonds?

Yes, you can buy individual TIPS or I Bonds. Alternatively, you can also invest in TIPS through bond funds or ETFs.