A primer on I bonds vs. TIPS
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When you own TIPS in a taxable (nonretirement) account
you have to pay income tax on the inflation-indexed earnings each
year, even though you won't get that money until the security is
redeemed or matures.
You can currently earn inflation plus 2.15 percent
by buying the five-year TIPS. Why be happy with rolling over to
a 1.40 (fixed rate) plus inflation on the Series I bond? With TIPS
you can currently earn an inflation-adjusted return of 1.97 percent
to 2.15 percent. New issue Series I bonds have not earned that since
May 1, 2002. Don't let the inflation component turn your head. You're
looking for real (inflation adjusted) returns when you buy either
of these securities.
Another difference between the TIPS and the Series
I bond is that the TIPS will fluctuate in value over time since
they are marketable securities. That can work for or against you
depending on where prices go, but you may be willing to accept a
lower yield in the Series I bond just to avoid that volatility.
Still, you're contemplating paying an early redemption
penalty on some Series I bonds paying 1 percent fixed in order to
reinvest at the new fixed rate of 1.4 percent. Because of the
tax issues it's not a simple trade-off of picking up 0.40 percent
for one to four years versus losing three-months' interest. An
extra 0.40 percent is $4 per $1,000 bond annually.
You also want to optimize when you roll over the bonds. The
optimal time to rollover the bond depends on when it was issued. You
want to minimize the interest penalty, so you want to redeem when
the bond is earning the lower inflation component, not the higher
one. This issue is discussed in greater depth on Themoneyblogs.com.
But, early redemption not only triggers the interest
penalty, it also forces you to recognize the interest income. Don't
look at it as picking up 0.40 percent for 30 years because, at year
five, the original bonds can be redeemed without penalty and you
can decide at that point whether to continue to own them or reinvest
at the fixed rate offered at that time.
I don't have anything in my crystal ball about where
inflation is headed over the short to intermediate term. It's clear
that the Federal Reserve Board is doing its best to keep it under
control. If you can afford the larger denomination TIPS with its
$1,000 minimum denomination purchase, I'd avoid Series I savings
bonds until they were more competitive with TIPS -- unless you plan
on using the Series I bonds in the Savings Bonds for Education program
and taking advantage of the tax savings available in that program.
To ask a question of Dr. Don, go to the "Ask
the Experts" page and select one of these topics: "financing
a home," "saving & investing" or "money."
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