Any discussion of TIPS requires an additional mention of Series I Savings Bonds. I Bonds can be purchased in taxable accounts from Treasury Direct without paying any fees or commissions.
They work like a CD as they are not tradable on secondary markets. I Bond yields are quoted in terms of a real interest rate, and then earn realized inflation on top of that. Like TIPS, they offer constant real returns but variable nominal returns.
I Bonds must be held for at least one year. If sold within five years, there is a penalty of three months’ worth of interest. Beyond this point, they can be sold at any time, and they accumulate interest for up to thirty years.
There are no coupon payments, as accumulated interest is received when the I Bonds are sold. This interest is all tax-deferred until the bonds are sold, despite being held in a taxable account. Like all U.S. Treasuries, they are exempt from state and local taxes.
They offer such a great deal that the government limits the annual purchase amount to $10,000 per Social Security number, plus an extra $5,000 allocated from a tax refund.
Unlike TIPS, I Bonds are not exposed to interest rate risk. There are no capital losses if rates rise, but also no capital gains if they drop. If rates rise, it might be tempting to sell your I Bonds in order to buy new higher rate I Bonds, but the annual purchase limit puts a damper on such plans.
For long-term planning, a thirty-five-year old couple could begin purchasing $20,000 of I Bonds per year for the next thirty years. Then, at age 65, they would already have a thirty-year ladder of an annual inflation-adjusted $20,000 of real purchasing power as part of their reliable income for retirement.
Those with less time before retirement could make adjustments to this strategy accordingly.
Next time, we’ll discuss duration-matched bond funds and how you can use them in your retirement plan.