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Inflation fears? Buy savings bonds, TIPS

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Dear Dr. Don,
I expect inflation to greatly increase this year or next. Where should I invest?
— John Jumpstart

Dear John,
With your outlook, you would want to invest in securities indexed to the rate of inflation. The U.S. government offers two types of investments that fit the bill: Treasury Inflation-Protected Securities, or TIPS, and Series I savings bonds.

While both are issued by the U.S. government, you should understand important differences between the two types of investments before deciding to invest in these securities.

TIPS are marketable securities, currently sold in five-, 10- and 20-year maturities. The value of the securities fluctuates with changing interest rates and inflation expectations. You can buy TIPS in your brokerage account, or set up a TreasuryDirect account and buy them directly from the U.S. government.

You can also buy TIPS through owning shares in a bond mutual fund, like Vanguard Inflation-Protected Securities, or VIPSX) or Fidelity Inflation-Protected Bond Fund, or FINPX. Exchange trade funds like the iShares Barclays TIPS Bond (TIP) also offer exposure to TIPS.

(For purposes of full disclosure, I’ll note that I own shares of VIPSX and have accounts with Fidelity and Vanguard.)

Series I savings bonds are not marketable securities and have a minimum holding period of one year. You lose the last three months’ worth of interest if you redeem the bonds in the first five years of ownership. They are available at many banks. Or, you can buy and hold them in a TreasuryDirect account.

There are limitations on how many savings bonds you can purchase in a calendar year. An advantage of the savings bonds is that you can defer paying income tax on the earnings until the bond is redeemed or matures.

Some municipal bonds are indexed to inflation. The advantage to municipal bonds is that the interest income is exempt from federal income taxes. It may be exempt from state and local income taxes, too, depending on the location of the issuer and the residency of the bondholder.

Municipal CPI bond offerings are fairly rare. You could try to pick one up in the secondary market, or ask your broker to keep an eye out for new issuances.

Tax considerations play an important part regarding which inflation-indexed investment is right for you. In general, investors prefer to own TIPS in tax-advantaged retirement accounts because they don’t have to make annual income tax payments on the inflation adjustments.

Be sure to discuss this investment with your tax professional if you don’t understand the tax impact of these different inflation-indexed investments.

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