Are TIPS Worth Adding To Your Retirement Portfolio?

With the growing U.S. federal deficit, tariffs, fears of recession, and upcoming tax breaks, inflation is still looming in the minds of many retirees and soon-to-be retirees. And one of the most commonly pitched strategies out there to combat inflation is TIPS, or Treasury Inflation Protected Securities. But do they really preserve your purchasing power in a meaningful way and kill off inflation no matter what happens? Or are they just another government bond with a fancy name and a built-in marketing hook?

Hello, and today we're tackling a question that I hear all the time, which is, are TIPS worth adding to my retirement portfolio? And no, we're not talking about the kind of tip that you leave at a restaurant or for your hairdresser. I'm talking about Treasury Inflation Protected Securities, or TIPS. And that's the government's way of helping you keep pace with inflation without having to become an economist or a fortune teller. In this episode, we're going to break down how TIPS work, different options for investing in TIPS, the taxation of TIPS, we'll look at how they behave in different interest rate environments, and whether or not they truly earn their keep in a retirement income plan or a portfolio throughout retirement. I'll also cover a few sneaky pitfalls of TIPS, whether you're building a retirement income plan or just trying to outpace the rising costs of eggs and Starbucks. If you're trying to beat inflation over the long run without losing sleep or sacrificing income, this one's for you. So grab your expensive coffee and let's get into it.

[00:02:10]
Okay, so let's start with what TIPS are and how they work. And while I usually hate to get into the weeds and the nitty gritty on certain investments, because some of the stuff can confusing, I do kind of want to dive into the weeds on TIPS just because I think their inner workings are so crucial to understand if you're ever going to consider them for your portfolio. So hang in there with me. TIPS, again, stands for Treasury Inflation Protected Securities. They're a type of government bond, which basically means when you purchase one, you're lending money to the U.S. government, and they promise to pay you back with interest. Historically, what better debtor to have than the U.S. government? Although recently, that thought may be changing, but I digress. But here's what makes TIPS special.

They are designed to protect or preserve your money rather from inflation, that slow rise in prices that makes everything more expensive over time. Let's introduce this concept of TIPS using a basic example. Let's say you buy a five-year TIPS bond with a par value of $1,000, and it has an interest rate of 1%. With a normal bond, you'd earn 1% on that $1,000 every year.
So $10 a year. And actually, they pay semi-annually. So technically, you would get $5 every six months in this example. But what makes TIPS so different from a regular bond is that the government adjusts the $1,000 based on inflation each day, technically, but every time you get a payment, you'll see a difference in that payment because they're going to adjust it for whatever inflation did.

[00:04:04]
And they make this adjustment based on something called the Consumer Price Index, or CPI, which is basically the worldwide measure that most people will look at to account for what's going on with inflation. To simplify, if inflation goes up 3% this year, your $1,000 becomes $1,030, which is $1,000 plus a 3% adjustment because of that inflation. Then you earn 1% interest on $1,030 instead of on your $1,000. So now your new payment, instead of being, again, simplifying to $10 a year, it would be $10.30 a year. If inflation keeps going up, your investment keeps growing, and your interest payments grow with it until the bond matures.
However, there’s a big caveat here. TIPS are adjusted for both increases and decreases in inflation. If inflation goes down, the principal value of your TIPS can decrease, and your interest payments will shrink accordingly. Here's an example that mirrors the last one, but now we'll assume deflation or a drop in prices. Let's say you buy $1,000 in TIPS, and the fixed interest rate is 1% annually. So again, half of that is paid semi-annually, so 0.5% is paid every six months. Over the year, the CPI shows an adjustment of negative 3% in deflation. So prices fell by 3%. After six months, there's going to be a minus 1.5% CPI adjustment in your payment. So the principal will be adjusted down by 1.5%. So that's $1,000 minus that 1.5%. That would be $985. That's your new principal on your TIPS bond.

[00:06:07]
The interest payment would then be $4.93, which is 0.5% of the $985 of principal. Remember, before the change, it was just a basic 1% split in half, and that would have been $5 every six months. So now, in this case, it's only $4.93. In this example, after twelve months, there would be a total of a negative 3% CPI adjustment. So your principal at the end of this is now $970, which is again, $1,000, taking out that 3% adjustment.

The next interest payment would be $4.85, which is the same 0.5%, but multiplied by an even lower principal amount of $970. So, as you can see here in this example, if we just kind of had a perfectly even deflationary scenario, and the year ended at negative three, then you would see your principal being adjusted down each payment. Hopefully, that makes sense. Again, this is sort of a simplified example, but there's a built-in floor, so to speak, sort of. If you hold TIPS to maturity, which means, again, if you bought like a five-year TIPS bond, you purchase the bond and hold it all the way until the fifth year, until it matures. You are guaranteed by the U.S. Treasury to get back at least your original principal, even if deflation lowers the value during the life of the bond, while you were holding it. If you hold the bond until it matures, you receive the greater of the inflation-adjusted principal or the original face value, which is typically $1,000 per bond, depending on how you we will get into shortly.

[00:08:03]
However, during the bond's term, while you're holding it and before it matures, your principal and interest payments can still go below $1,000 or par value due to deflation, like we just discussed. So if you were to try to sell your bond early, because you needed to, let's say, spend that money, you may have to sell your bond at a discount. The opposite is true if we are experiencing inflation, and you go to sell your TIPS. They could be worth more. Again, this was a simplified example. The principal adjusts based on that CPI daily, and there's actually a two-month lag when measuring the CPI before they make the adjustments to the payments.
But again, I don't want to get too deep into the weeds here. I just want to tell you pretty much exactly what you need to know in order to make better decisions around TIPS.
What are the important things to know when buying TIPS? You can own TIPS in a retirement account, such as an IRA, Roth IRA, etc., or in a non-retirement account, such as just a plain old brokerage account. TIPS can be accessed through several means nowadays, including buying the individual TIPS themselves, or through a mutual fund that employs a TIP strategy of some or even through an ETF structure. However, there are some major differences when buying an individual TIPS security versus owning them through a fund like a mutual fund or ETF that you need to understand. So let's start with buying individual TIPS. When you're buying TIPS bonds individually, there are two means of getting them. The first one is directly from the borrower, which, as we discussed, is the United States Treasury. And we call this buying at issue or buying newly issued bonds. This is done online via a website called TreasuryDirect.gov.

[00:09:58]
When buying newly issued TIPS on TreasuryDirect.gov, you can only buy them in a non-retirement account. If you want to purchase newly issued TIPS in a retirement account, you have to do it through the custodian of your account, wherever that brokerage account is. Lastly, when purchasing, they are listed at a par value of $100, not $1,000 when buying them directly from the United States Treasury. The minimum purchase is $100, and you can buy in increments of $100. So you can buy a hundred dollars worth, $200 worth, $500 worth, anything in increments of $100. The second way to purchase is on the secondary market. No pun intended. This simply means that you are buying TIPS from someone else. They are not newly issued by the United States Treasury. In other words, you are not the first buyer.

Typically, you buy TIPS on the secondary market through your custodian or brokerage. The bonds may trade at a premium or discount to their original par value. The bonds are usually quoted in $1,000 increments when you're getting them on the secondary market, even though they are technically still based on the $100 face value units issued by the treasury originally. Now, usually when shopping for TIPS through a brokerage, you'll find the prices stated as a percentage of $1,000 par value. For example, you may see $102.5, which simply means $1,025, which would mean in that case that it's selling at a premium, selling for $25 more than par value of a thousand. Another thing to know is the different maturity options when buying TIPS. TIPS are slightly different from other bonds in the sense that they are only issued currently in five, ten, and thirty-year maturities.

[00:11:58]
Five-year TIPS would be considered if maybe you had a short-term liquidity need, ten years are probably the most common and most liquid. And thirty-year TIPS are for those individuals and institutions that want a very long-term inflation hedge. Each maturity has its own risks and uses depending on the buyer's goals. Now, instead of buying TIPS individually, you can certainly get exposure through fund like investment vehicles, such as mutual funds or ETFs, as I mentioned earlier. So instead of trying to buy them individually, which can be quite cumbersome for many investors, you can buy a TIPS mutual fund or ETF, also known as an exchange-traded fund. And this route offers convenience and rather immediate diversification, and it can be done at a relatively low cost. There are some other ancillary benefits as well.

For instance, you can buy and sell more often. If there's a liquidity need, you can buy or sell essentially however much as you want. So you're not really stuck to the hundred-dollar increments or thousand-dollar increments. The taxation is quite simple to deal with and report compared to buying individual TIPS. The interest is typically paid monthly instead of semi-annually with the individual TIPS. So a lot of investors like that, and these different funds typically own dozens of different TIPS at differing maturities. So you don't own just one TIPS security.

However, with that, you can also lose some control by investing in the fund route. It doesn't mean that it's always better. Some investors may prefer to purchase very specific timeframes and maturities so that the income they receive matches a particular income goal they have, or maybe they want to build a sort of TIPS ladder for a specific goal that starts to get really difficult with a fund.

[00:13:58]
You can also reinvest the interest from the funds automatically and put it back to work right away, which is much harder with just individual TIPS. Because remember, if you're buying, let's say on the secondary market, they're going to be a thousand dollars, give or take. There might be a premium or a discount there, but you can't just take a small amount of interest and automatically reinvest it back into the individual TIP, because you may not have enough to buy just one. And of course, TIPS funds will have an expense that is paid to the manager of the fund, whether it's an active, let's say, mutual fund or a passive index fund that invests in TIPS.

But as I said, the cost can be manageable depending on the funds that you choose. If you were to engage in a lot of activity when buying or selling individual TIPS, on the other hand, you may incur many different individual transaction charges or even markups when buying on the secondary market. So there are costs to both. When buying a TIPS fund, you would simply use a brokerage account, and that can be a retirement account or a non-retirement account. There are many different funds to choose from. So do your due diligence or talk with your advisor.

Now I want to be sure to go over a few of the caveats and potential risks with TIPS. I also want to remind you that TIPS are still bonds, and therefore their price will still react to interest rate movements. For example, when interest rates rise, new TIPS are issued with higher real yields. In other words, better fixed rates. Existing TIPS that are on the secondary market become less attractive, and that's because they pay lower fixed interest. So their market prices should fall, and you could face a paper loss if you sell your bond in this instance before maturity. For example, throughout 2022, the price of the broad TIPS market fell by almost 20% due to the sharp increases in interest rates. If you were to sell your TIPS early during that time, you likely would have incurred a loss.

[00:16:04]
On the other hand, when interest rates fall, existing TIPS should look more attractive because they've locked in higher real yields than the new ones that are being issued while interest rates have fallen. Their market price should rise. So you could sell at a premium rather than holding them until maturity, if that's part of your game plan. But then you have the issue of finding out where to reinvest the money, unless, again, you plan on spending it. So yes, TIPS can lose value in a rising interest rate environment and gain value when interest rates fall, just like normal treasury bonds, or other types of bonds like corporate bonds. So to summarize this point, if market interest rates have risen sharply, the price of your bond will likely fall, and this affects all bonds, including TIPS. This means that while you're TIPS, the value of your portfolio can and will fluctuate, although usually not as much as something like a stock would.

However, TIPS still may perform better than regular, what we call nominal bonds in these rising rate scenarios, because the market value of TIPS depends on how real yields change, not nominal interest rates alone. Let me help explain what I mean here. A real yield simply means the yield after adjusting for inflation, while the word nominal is the yield before inflation. In other words, a nominal yield tells you how much interest you're earning, but not how much purchasing power you are actually keeping. TIPS are quoted in terms of real yield. This yield is on top of whatever inflation adds to your principal, like we talked about earlier.

[00:17:58]
So if a 10-year TIPS is offering a real yield of one and a half percent, that's what you'll earn above inflation. If nominal rates rise because of inflation, TIPS may hold their value better than regular bonds. Remember, because their principal increases with inflation. Here's another example to help make sense of this. Let's say you hold a 10-year TIPS with a 1% fixed rate, and let's say the principal is $1,000. Now, imagine interest rates rise and new 10-year TIPS offer a 2% real yield. Your 1% TIPS is less attractive, so its market value drops, but your inflation adjustments continue, which kind of cushions the blow. If you hold to maturity, you still get all your inflation adjustments and your full principal. But if you sell it early, you might end up selling it at a discount in a rising rate environment, and you might incur a loss.

Okay, so now that we have a better understanding of how TIPS work and how we can purchase them or invest in them, what about the taxes on TIPS? How does that work? Sorry, but when the current administration mentioned no tax on TIPS, they didn't mean these kind of TIPS. The bottom line is that taxes on interest income, inflation adjustments, and potential capital gains can affect your net profit and likely will. When you own individual TIPS in a non-retirement account, the interest paid, or dividends paid if you own them via a fund, are taxed as ordinary interest at your marginal tax rate. The inflation adjustment you receive on your principal is also taxed as ordinary interest, not capital gains, as many people may assume. This is an interesting phenomenon because you don't actually get paid that inflation adjustment on your principal until the bond matures, but you'll still owe taxes on it year by year as they adjust it.

[00:20:09]
This is something called original issue discount, or OID. It's kind of a nerdy tax term. On the other hand, if there's a deflation while you own the bond, and your bond is adjusting downward over time, you can deduct against the interest paid to you during a given year, so it kind of has an opposite effect. Just know that there are some other tax nuances as well when buying individual TIPS that I won't get into now, but just know that the taxes are a little more cumbersome when you buy individual TIPS versus buying them through some sort of fund structure. When you buy a fund that invests in TIPS on your behalf, they too will distribute income to you, although it's typically monthly instead of semi-annually, and that income is also taxed as ordinary income, but you don't need to worry about the other issues like original issue discount and some bond amortization and things of that sort. The good thing, though, about TIPS, regardless if bought individually or through a fund, is that because they are issued by the US government, they aren't subject to state taxes. But here's a pro tip that I just have to share.

I have found in practice that many people or their tax preparers forget to back out the interest earned from TIPS on their state tax return. That being said, you'll only get this benefit if you report it correctly on your tax return, and for most tax software out there, this isn't automatically done. It's a manual thing that you have to know to look for, so keep an eye out for that. You could possibly incur what we call a capital gain or loss on TIPS as well, but this is only if you were to sell before they mature and the principal is higher or lower than the amount you initially paid, and you own them in a non-retirement account. So be mindful of this as well.

[00:22:06]
One more really important thing that I want to mention on the tax side is that after taxes are paid on your investment, you may not actually earn a rate of return over and above inflation. However, this would be the same with traditional bonds as well. And just as a side note, after tax returns are all that matters because that's the return that goes in your pocket. Make sure you understand what your after-tax return goals and expectations are, and be sure that you're implementing TIPS in the most efficient investment vehicle for your situation. What I mean is one thing you can do to avoid this tax craziness, if you want, is to consider buying them in your retirement accounts instead of non-retirement accounts. You don't have to, but it's just one strategy. By owning TIPS or TIPS-based funds in a retirement account, you don't pay the taxes year to year since these accounts are tax-deferred. You simply pay taxes due on the amounts that you withdraw from your retirement account in the year you withdraw them. Or if you purchase TIPS inside a Roth account, there will be no taxes at all if it's a qualified withdrawal.
You can kind of get creative. There are some cool strategies you can utilize when you have both retirement and non-retirement accounts, and you've decided that you want to own TIPS.

So why would an investor or a retiree consider investing in TIPS? Well, investors buy TIPS for most of the same reasons they buy other bonds. They want to earn interest income. They maybe want to mitigate inflation risk in their investment portfolio and for their retirement income. Or they want to speculate, maybe on changes in interest rates, which I don't suggest doing ever, by the way, that is next to impossible and a very dangerous game to play.

[00:24:02]
They also buy them for their high quality because they're backed by the full faith and credit of the United States government. But helping a stream of income or portfolio combat inflation, I'd say, is the primary reason investors buy them compared to a normal bond. A good metaphor for buying TIPS is like you're buying insurance on future unexpected inflation. But depending on what actually happens with inflation, you may have been better off with a traditional nominal bond, a normal bond. So, just know that there are risks with TIPS, just like anything else. Overall, I don't think anyone should just buy TIPS alone with their fixed income allocation. If you deem they’re right for you, they should be part of an overall diversified portfolio, or they can be looked at as a segmented bucket of your overall portfolio that is there to meet a specific goal. Once you've identified the goals for your portfolio, you need to ask yourself whether or not you need to keep up with inflation or beat inflation outright after taxes. For younger investors, and I'd argue many retirees even, who have a long time horizon, such as 20-30 years for a specific goal, might be able to beat inflation by owning other assets, such as stocks or equities. Historically, stocks have outpaced inflation over the long run by a fairly wide margin. Although by owning stocks or equities you will surely experience more volatility in your portfolio day by day, they’re not bonds. It's important to know that TIPS aren't a replacement for stocks per se, but again, it all depends on your objectives. I know saying it depends isn't the answer you want, but it's true.

[00:25:57]
In summary, TIPS can definitely serve as an inflation hedge in a diversified portfolio, but you'll want to establish clear goals for your money first. It's also important to know how they differ from traditional bonds and the tax nuances when purchased outside of a retirement account. Secondly, TIPS aren't designed to build wealth above and beyond inflation, but merely as a means to potentially keep up the purchasing power of your dollars. And lastly, TIPS still have varying risks that are important to understand. They're not a sure-fire replacement for traditional bonds just because they have the ability to keep up with unexpected inflation.

That does it for today's show. If you find the topic discussed actionable and insightful, do yourself a favor and subscribe to or follow the show on your podcast app. That way, you can get an alert each time a new episode drops. Also, be sure to check out our free Retired-ish video newsletter to get more useful information on retirement planning, investments, taxes, once a month, straight to your inbox. The newsletter often dives deeper into some of the topics discussed on the show, as well as useful guides and charts available for download. As always, you can find the links to the resources we have provided in the episode description right there on your podcast app, or you can head over to retiredishpodcast.com/72. Thanks again for tuning in and following along. See you next time on Retired-ish.

[00:27:46] Disclosure
Cameron Valadez is a registered representative with, and securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.

The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual.

To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

All investing involves risk, including loss of principal. No strategy assures success or protects against loss.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise in bonds are subject to availability and change in price.

Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principle and interest, and if held to maturity, offer a fixed rate of return and fixed principle value.

Treasury inflation protected securities or tips are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. They're subject to market an interest rate risk if sold prior to maturity. If sold prior to maturity capital gain tax could apply. Interest income may be subject to the alternative minimum tax.

Tax and accounting-related services offered through Plan-It Business Services DBA Planable Wealth. Plan-It Business Services is a separate legal entity and not affiliated with LPL Financial. LPL Financial does not offer tax advice or tax and accounting-related services.