As inflation becomes more prevalent, TIPS and I Bonds have gained attention as vital tools for protecting against rising prices. I Bonds offer yields tied to inflation rates, while TIPS have a fluctuating principal that increases or decreases based on inflation. Investors typically compare TIPS and I Bonds as investments to protect themselves against inflation.
Summary:
- TIPS and I Bonds are bonds issued by the U.S. government. While both aim to protect against inflation, they accomplish this differently.
- I Bonds have an annual purchase limit of $150,000. TIPS do not have a purchase limit.
- I Bonds can only be bought and redeemed from TreasuryDirect, whereas TIPS can be bought on brokerages in addition to 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.
Recognizing this, the U.S. Treasury developed two types of bonds to protect investors from inflation.
The first bond type is Treasury Inflation-Protected Securities (TIPS), introduced in 1997. With TIPS, the principal amount rises when inflation does, while the interest rate remains fixed. Because your principal is increasing, your interest payments also go up.
The second type of bond is the 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.
How Do TIPS and I Bond Adjust to Inflation?
Let’s see how both adjust to inflation using some simple numbers. We’ll assume an initial investment of $1,000 and an annual inflation rate of 2%.
TIPS have an adjusting 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 the 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, as will the interest payments.
I Bonds have a combined rate comprising a fixed and 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 we use the assumed inflation rate of 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.
Differences Between TIPS vs. I Bonds
There are three critical differences between TIPS vs. I Bonds.
The first difference 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, they have different maturities. 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 are taxed differently. 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 and 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 |
Redeeming TIPS or I Bonds Before Maturity
If you redeem your TIPS, you will receive the bond’s current value, 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.
Buying Individual TIPS or I Bonds
Individual TIPS or I Bonds can be purchased on TreasuryDirect. You can also buy TIPS through most major brokerages or through TIPS bond funds and ETFs, which are funds holding a diversified portfolio of TIPS.
How to Choose Between TIPS vs. I Bonds
Both I Bonds and TIPS were created by the U.S. Treasury to protect investors from inflation. They’re extremely investments backed by the full faith and credit of the U.S. government. With both investments, your principal will be paid back as long as you hold to maturity. I Bonds pay 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 through a changing principal.
Some investors may choose to buy bonds that aren’t directly indexed to an inflation index. These include floating rate notes or their ETFs, which pay an interest rate tied to the 13-week Treasury bill rate, or Treasury bills, due to their short-term maturities and highly liquid market.
