TIPS: The Perfect Hedge Against Inflation

A Few, Er, Pointers on TIPS

Investors have a decent number of options when it comes to buying TIPS, and the one that works best for them depends on a few factors -- including tax matters.

First, you can buy them directly through the Treasury Department. The agency sells TIPS in $1,000 increments at auctions in January, April, July and October -- it even has a Web site that sells them. Individuals can also purchase them at any time through a broker, where fees may come into play. The recent 10-year TIPS auction has a 1.875% fixed interest rate. When you own TIPS, you receive interest payments every six months and a payment of principal when the security matures. Individuals can also purchase a TIPS mutual fund, such as the (VIPSX Quote)Vanguard Inflation-Protected Securities fund.

What are the pros and cons of each option? In some areas, buying TIPS directly gets the edge. First off, you don't need diversification when buying TIPS or other federal government securities, neutralizing a key benefit of mutual funds: diversification. Also, direct purchases are cheaper. Vanguard's TIPS fund carries a tiny 0.22% expense ratio, but it's still 0.22% more than buying TIPS directly.

A big upside of a TIPS mutual fund for investors (like my friend) is that they're much easier to get ahold of in 401(k) plans or other tax-deferred investment plans. This brings us to a crucially important component of TIPS investing: "Only buy TIPS in a tax-deferred account," said Larry Swedroe, principal of Buckingham Asset Management.

Investors must pay taxes on the inflation adjustments of TIPS, while the adjustments themselves aren't paid out until maturity. If inflation shoots up as the economy recovers, investors could be footing a tax bill that actually exceeds the income paid out!

Looking for an inflation-hedged investment for a taxable account? A better option would be I Bonds, another inflation-adjusted Treasury security that individuals can purchase at www.treasurydirect.gov. With I Bonds, no taxes are due until maturity.