Protect your savings from inflation

Take $1,000, stash it in a one-year CD, and at the end of a year you'll get back $999.30. Sound like a good investment? That's what happens when a one-year CD yields 1.73 percent and inflation is 1.8 percent.

When inflation is low, people have a tendency to ignore the fact that it's still gnawing away daily at their savings, weakening already anemic interest rates and making them desperately in need of a transfusion. Or, in our example, it's beyond gnawing, it's devouring.

The number of ways to protect your savings from inflation is growing.

Money back, guaranteed
Treasury Inflation-Indexed Securities are better known as TIPS. Apparently, the government used the word "indexed" when naming the securities, but everyone else called them inflation-protected; hence the acronym TIPS.

TIPS are notes that are guaranteed to give you a real rate of return. If you buy a TIP for $1,000 and are told the interest rate is 3 percent, that's what you'll get. Using the Consumer Price Index, the government adjusts the value of your principal every six months to account for inflation. The semiannual fixed-interest payment is applied to the inflation-adjusted principal.

"If the CPI went to 102, meaning inflation went up 2 percent, we'd adjust the principal up by 2 percent," says Peter Hollenbach, spokesman for the U.S. Treasury's Bureau of Public Debt.

"The $1,000 you invested is now worth $1,020 and the interest payment would be $15.30."

If there's deflation, your principal is adjusted in the opposite direction. But don't worry, you're guaranteed to receive your original principal at maturity.

TIPS are issued with 10-year maturities and the current interest rate is pegged at 3 percent.

You don't pay state or municipal taxes on TIPS, but you do have to pay federal tax on the interest and the inflation adjustments to the principal. Even though you don't pocket the money until maturity, those inflation adjustments are considered income and taxes are due each year.

You can avoid paying the tax, for a while anyway, by stashing TIPS in a tax-deferred account. Better yet, put them in a Roth IRA and don't pay any tax.

You can buy TIPS directly from the government through its TreasuryDirect program. The Treasury holds three TIPS auctions each year: January, July and October. The site takes you through the steps of placing a noncompetitive bid, which allows individuals to pay the same price for the security as the dealers who are buying them in lots of $1 million.

You won't pay a fee or commission when you buy through the government. You can buy TIPS any time during the year through brokers and some banks, but you'll pay a fee.

TIPS are issued with 10-year maturities.

Inflation-protected funds
There are probably less than a dozen mutual funds that put all or most of their money into inflation-indexed securities. They're becoming more popular as fund companies struggle for ways to hold on to the billions of dollars market-weary investors are siphoning out of stock funds. Fidelity created an inflation-protected fund this year; Vanguard joined the fray last year. Some others, that we'll name later, actually have five-year records you can use for comparisons.

If you don't want to mess around with buying individual TIPS, keeping track of different maturities and reinvesting the proceeds, a fund can be the way to go.

Many of these funds have year-to-date returns of 15 percent. But, right off the bat we'll warn you, don't expect these returns to continue. The demand for these securities has driven their prices higher. As with any bond fund, there is no maturity date and the share price can fluctuate. If you sell at the wrong time, you could lose money.

The funds share the same tax situation as TIPS. You pay tax on phantom inflation adjustments, so it's best, again, to hold these in a tax-deferred account.

"The two big factors are cost and convenience," according to Morningstar analyst Scott Berry.

"You always want to look at total return and see if a particular fund manager has added more value than the others. But, if it's a plain vanilla Treasury fund, cost is the big difference."

Buy no-load funds, funds that have no upfront sales charges. Some may tack on a redemption fee if you sell the fund within a certain time frame.

Berry says inflation-protected bond funds are a good hedge against inflation, but they're meant to round out a portfolio rather than be a heavily weighted holding.

Here are some funds you may want to consider.

• American Century Inflation-Adjusted Bond Fund (ACTIX)
• BBH Inflation-Indexed Securities (BBHIX)
• Fidelity Inflation-Protected Bond Fund (FINPX)
• GMO Inflation Indexed Bond Fund (GMIIX)
• PIMCO Real Return Bond Fund (PRRDX)
• Vanguard Inflation-Protected Securities (VIPSX)

I bonds
Series I bonds are the inflation-adjusted version of the savings bond. The difference between them and TIPS is that the Treasury factors inflation into the interest rate instead of the principal. The adjustments are made every May and November.

I bonds, which are issued with 30-year maturities, generally have a lower interest rate than TIPS. I bonds are currently paying 4.08 percent. But there are some differences to keep in mind.

I bond interest payments are added to the principal, and you don't have to pay taxes on that money until you cash the bond. Therefore, it's not necessary to keep the I bond in a tax-deferred account to reap the benefits of tax deferral.

If you use I bonds for qualified higher education expenses, you may be able to avoid paying taxes on the gains.

Also, $50 will buy you an I bond vs. the $1,000 you need to shell out to buy TIPS.

You can buy up to $30,000 of I bonds per year, per Social Security number, by contacting the Treasury's Savings Bonds Direct Web site. You can also buy them from most banks, credit unions and savings institutions.

If you don't care about getting a paper I bond, you can get the electronic version for as little as $25 through TreasuryDirect.

Essentially, you open an account with TreasuryDirect that's linked to your bank account. You can add to or withdraw money from the bond account at any time. If you had a $1,000 bond and needed $100, you could deduct the $100 and transfer it back to your bank account without cashing the whole bond.

If you cash an I bond within the first five years, you'll forfeit three months' earnings.