This post was originally published on this site
Inflation punishes savers by diminishing the purchasing power of the money we’ve saved. After a decade of low inflation, this topic is once again on a lot of investors’ minds.
Bonds, especially those with low interest rates and longer durations, are particularly susceptible to inflation. There are bond options which can mitigate the impact of inflation: I Bonds and Treasury Inflation Protected Securities (TIPS).
When I was building my portfolio, I elected to allocate a portion to TIPS. I did not allocate any money to I Bonds. Being someone who is a buy and hold, set it and forget it investor, I haven’t thought much about this topic in the decade since.
Recently I revisited the topic of I Bonds vs. TIPS, and then decided to change our strategy moving forward. It’s worth taking the time to understand the role of I Bonds and TIPS in a portfolio, the differences between them, and which better suits your investment needs.
Similarities and differences between I Bonds and TIPS
Let’s start with the similarities and differences between I Bonds and TIPS, which will inform which best meet your investment needs.
Both I Bonds and TIPS are bonds offered by the US government. As such, both have a low default risk. You can purchase either of them directly through the TreasuryDirect website.
Both I Bonds and TIPS have a fixed interest rate that is set at the time the bonds are issued. Each also adjusts the amount you earn based on inflation. The inflation adjustment for both I Bonds and TIPS is indexed to the Consumer Price Index (CPI). However, the method of making the inflation adjustment is different for each.
I Bonds accrue interest over 30 years or until they are redeemed. Interest is paid every six months. There is an inflation component to the interest rate that is adjusted so the total interest payment is the fixed rate plus the inflation adjustment.
TIPS are offered with 5-, 10- and 30-year terms. They also have a base interest rate that is fixed over the life of the bonds. With TIPS, the principal is adjusted to inflation monthly. Interest calculations are then based on the adjusted principal.
Options to hold to maturity or sell
You can hold both I Bonds and TIPS for their full term until maturity. If you don’t want to hold the bond until full maturity, the options to sell are different.
I Bonds have to be redeemed directly through TreasuryDirect. They can not be sold on the secondary market. You can not redeem your I Bond for one year after it was purchased and you lose three months interest if you redeem between one and five years after you buy it. In this way, I Bonds function more like certificates of deposit than bonds.
You can buy and sell TIPS through the secondary market at any time. In this way they function like most other bonds.
Tax treatment
Both I Bonds and TIPS are subject to federal taxation. Both are exempt from state and local income tax. I Bonds do have a few tax advantages over TIPS.
You can defer paying federal taxes on I Bonds until the bond is redeemed or it reaches full maturity. Alternatively, you could elect to pay interest annually. In addition, I Bonds may be exempt from federal income tax if they are used to pay for qualified higher education expenses. Find details of the Education Tax Exclusion here.
TIPS are taxed differently. You will owe federal income taxes on interest payments and inflation adjustments annually, even if you don’t sell the bond or receive any income from it because the gains may occur in an upward adjustment of the principal. TIPS are not excluded from taxation if used for educational expenses.
While TIPS and I Bonds have many similarities, the differences offer advantages of one over the other depending on your circumstances.
Advantages of TIPS
Several features of TIPS make them preferable in certain situations.
Convenience. An advantage of TIPS is convenience. Upon revisiting this subject, I recalled this was the reason I initially chose them over I Bonds. You can create an account and buy both I Bonds and TIPS directly through TreasuryDirect. However, you can also conveniently buy TIPS in a bond fund through most brokerages where you already invest without setting up an additional TreasuryDirect account.
There is essentially no limit on how much money you can put into TIPS at one time. If using a TIPS fund, you’re limited only by the rules established by the particular fund. If buying TIPS directly, you may purchase up to $5 million worth at a single auction.
Conversely, you are limited to purchasing $10,000 per person per year of electronic I Bonds through TreasuryDirect. You could buy up to an additional $5,000 per person per year of paper I Bonds by overpaying your income taxes through the year and then receiving the refund in the form of I Bonds rather than cash.
If you want to slowly build a position in inflation-protected bonds, buying I Bonds is a reasonable option. But if you want to reallocate a portion of a relatively large portfolio to inflation protected bonds, using I Bonds could take years.
I own TIPS in Vanguard’s Inflation Protected Securities Fund Admiral Shares
VAIPX,
Rather than having to open a separate account with TreasuryDirect and taking several years to build a position, I was able to do it in seconds with a click of a button.
Potential price appreciation. When interest rates decrease, the value of most bonds increase. This is because newly issued bonds offer lower yields, so the older bonds with higher yields are more valuable when sold on an open market. This is the case for TIPS.
There is no secondary market for I Bonds. Selling them means redeeming them for the face value of the bond. Therefore I Bonds offer no potential upside for price appreciation.
No penalty if sold before five years. It is not uncommon to want to sell your bonds before they reach full maturity. Common reasons to sell bonds are because you need money to pay for living expenses in retirement or you want to reinvest in other options with more upside.
Because there is a secondary market for TIPS, you can sell them at any time. I Bonds restrict the ability to redeem them in the first year after they are issued. You are also subject to a penalty of three months interest if you sell an I Bond within five years. Only after holding an I Bond for 5 years can you redeem it without penalty.
TIPS are better in tax-advantaged accounts
TIPS can be bought and sold in any amount at any time, making them convenient to use when rebalancing a portfolio. It is typically best to rebalance within tax-advantaged accounts where you won’t owe taxes on any capital gains.
Taxes on TIPS are due annually, making them less tax-friendly in taxable accounts than I Bonds, on which you can defer paying taxes until the bond reaches maturity or you redeem it.
For these reasons, TIPS may be a better option in a tax-deferred account. Conversely, they may not make as much sense in a taxable account.
Advantages of I Bonds
While TIPS are superior to I Bonds in certain situations, I Bonds have clear advantages over TIPS in other situations. This is particularly true in our current environment with extremely low interest rates.
An interest-rate floor. I Bonds interest rates cannot go below zero. TIPS can, and as of this writing currently do, have negative interest rates.
This means buying an I Bond with a 0% fixed interest rate plus an adjustment equal to CPI guarantees that a dollar invested today will maintain the same purchasing power relative to the CPI over the life of the bond. The only way you can lose purchasing power is if your personal rate of inflation is higher than the CPI.
No interest-rate risk. As noted above, TIPS offer upside price potential when interest rates fall. The opposite side of that coin is that if interest rates go up, the value of TIPS will decrease.
I Bonds have a stable value. You can redeem them any time after 12 months from issue. Therefore, if interest rates rise, you have no risk of your bond dropping in value. With rates so low, this also makes I Bonds particularly attractive at the moment.
You do lose three months of interest if you sell the bond less than five years after issue. Otherwise, the only thing stopping you from selling your lower-yielding I Bonds and buying new ones with a higher yield if rates go up is the annual purchase limit.
Ability to defer taxes. I Bonds give you the option to defer taxation on interest earned or inflation adjustments until you redeem the bond or it reaches full maturity. This is not a feature of TIPS.
When you hold TIPS in taxable accounts, you owe taxes annually on both the interest earned and inflation adjustment to the principal of the bond, even if no money was received during the year.
This tax-deferral feature gives I Bonds another clear advantage over TIPS when held in taxable accounts.
Tax breaks for education expenses. When you redeem I Bonds for qualified education expenses they are completely tax free. This is not a feature of TIPS, making this another clear tax advantage of I Bonds over TIPS.
How I’ll be using I Bonds and TIPS
I Bonds are attractive compared to TIPS and other bonds at the moment. In times of very low interest rates, I Bonds eliminate the interest-rate risk that is present with the alternatives. I Bonds are a better bet to at least keep up with inflation than regular bonds. Because the interest rate on I Bonds can’t go below zero, they are a strong bet to outperform TIPS which function similarly to I Bonds, but are starting with the headwind of a negative fixed interest rate.
We will continue to hold our allocation of TIPS in tax-deferred retirement accounts. In the future, rather than adding to our core bond holding or buying more TIPS, we will first look to add I Bonds to diversify our portfolio when it is feasible.
If we were still in our accumulation phase and buying bonds, we would be aggressively buying TIPS. The challenge we currently face is finding the money to invest in I Bonds. We haven’t invested in taxable accounts since I left my job over three years ago. While I Bonds are attractive, when we have new money to invest I will continue to follow the order of operations I’ve written about in the past, prioritizing receiving the employer match on Kim’s 401(k), fully funding our HSA, and maxing out both Kim’s and my Roth IRA before investing in I Bonds.
There are two opportunities where I will be looking to purchase I Bonds.
I Bonds For education expenses
In the past, I shared that we bypassed using a 529 account to save for our daughter’s education fund. One reason is that we could invest for a lower cost outside of a 529. Another reason is that our relatively low income in semi-retirement makes taxable investment accounts tax-friendly. Investing in a taxable account allows us to avoid the additional complexity and potential restrictiveness of utilizing a 529 plan.
One potential downfall of our strategy is creating a tax bomb if we sell large amounts of highly appreciated taxable investments in one year, or over a couple of years, to pay for her education. Another issue is properly managing risk.
We front-loaded our daughter’s education funds during her first couple years of life. The money is invested 100% in a total stock market index fund. Because of a massive tailwind since then, we’ve more than doubled our money and met our financial goal a decade before we will need the money.
One thing we will start doing later this year is selling off $10,000 of her highly appreciated index funds each year and buying her I Bonds with the proceeds. This will serve two purposes.
First, we’ll gradually harvest capital gains at a 0% long-term capital gains rate to lower our future tax burden. We’ll also put the money in a place where it will grow tax-free and, if it is used for our intended purpose of helping our daughter with her higher education, we’ll access it tax free.
Second, we’ll be taking risk off the table by allocating money that currently is in volatile and richly valued stocks into more stable bonds, which should keep up with at least general inflation, if not inflation in education prices if it continues at past rates.
I-Bonds in taxable accounts when rebalancing
Traditionally, we have done all portfolio rebalancing in our tax-advantaged accounts. That’s because we don’t incur taxation on any short- or long-term capital gains that would be owed if rebalancing in taxable accounts. We’ve also avoided holding any bonds in our taxable accounts.
Now that we have a more tax-friendly lower income in semi-retirement, we can harvest gains from our taxable stock index funds at a 0% federal long-term capital gains rate. Moving forward, in years when we need to sell stocks and buy bonds to rebalance our portfolio, we’ll start selling taxable stock funds and buying I Bonds to diversify our bond holdings as long as we can do so in a tax friendly way.
Chris Mamula retired from a career as a physical therapist at age 41. This was first published as “I Bonds vs. TIPS: Which is Better?” on the blog “Can I Retire Yet?”
