TIPS vs I Bond: Which Inflation-Adjusted Bond Is Better?

Editor Vinci Palad
Contributor Alvin Yam

TIPS and I Bonds are inflation-adjusted IOUs issued by the U.S. Treasury. So, how are they different?

In this post, we break down the key differences between I bonds and TIPS so you can decide which is a better investment for you.

 

Key Takeaways:

  • Tips and I bonds are both inflation-adjusted, government-backed securities
  • Tips can be traded in secondary markets, while I bonds cannot.
  • I bonds are easier to purchase and redeem
  • TIPS are subject to market valuation and require careful consideration when selling on the secondary market.
  • I bonds don’t generate income or tax liability during maturity, while TIPS generates income and tax liability during maturity.

 

Glossary:

Before we dive into the difference between I Bonds and Tips, let’s begin with a few contextual definitions for the purpose of this post.

 

Bond – Bonds are debt investments where the investor lends capital to the borrower in exchange for a fixed interest rate.

 

Issuer – A bond issuer is the borrower or the entity you lend money to and is legally responsible for the obligations of the issue.

 

Bondholders – Bondholders are loaners, not owners. Bondholders essentially lend money to the issuer for a specified period and, in return, receive interest payments and the return of the principal amount at maturity.

 

Principal – the initial amount of money you lend to the bond issuer.

 

Maturity – Maturity is the point in time when the borrower is obligated to return your principal back to you as laid out in the bond’s contract. Short-term means the bond maturity is within five years or less. A long-term bond is anything beyond that.

 

Yield to maturity – The rate of return an investor expects to receive if held to maturity. The yield to maturity is the rate the investor will receive, barring some other negative event like the bond issuer going bankrupt or the bond getting called.

 

Interest Rates – The Interest rate of an investment refers to the amount of money an investor earns from an investment (particularly an investment in a fixed-income security). Interest rates are usually expressed as annual percentage yield (APY), although bonds typically pay every six months.

 

Nominal Treasury Bond – Bond issued by the U.S. Treasury. This type of bond guarantees a fixed return at maturity, but it is not protected from expected inflation. Expected Inflation is the rate of inflation that investors anticipate will occur over the bond’s life.

 

Mark to Market – Adjusting the fair value of your at a point in time. A bond’s price is inversely related to the interest rate. The lower the interest rate environment, the lower the yield one should expect to receive from a bond. Thus, the market will require a higher price for the bond, thus decreasing the yield to be in line with the market interest rates.

Now that we’ve reviewed the definitions let’s take a closer look at the difference between TIPS and I Bonds.

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What are TIPS?

TIPS, also known as Treasury Inflation-Protected Securities, are a special type of bond issued by the U.S. treasury that is indexed to inflation. When you buy TIPS, you lend money to the US government for a certain period of time, typically 5, 10, or 30 years. In return, the government pays you interest semi-annually at a fixed rate. However, the amount of interest you receive is based on the adjusted principal amount of the bond.

TIPS differs from nominal treasury bonds because its principal and interest are tied to the consumer price index (CPI). That means the value of TIPS rises and falls relative to rising or falling inflation.

An important note is that interest payments on TIPS are never less than the original principal amount of the bond. This means that even if inflation is negative, you will still receive at least the amount of money you originally invested. The principal value of the bond is adjusted every six months based on changes in the CPI.

Let’s say you lend the government $100 today, and they pay you back in two years. If, within those two years, the CPI doubles, the government will adjust the principal of your TIPS bond to $200.

The same goes for your interest payments. Say your expected interest payment is $1.00 for year one, and CPI doubles by year 10. Your TIPS interest payment would double, increasing to $2.00 by year 10.

Because both principal and interest are indexed to inflation, your TIPS bond is protected from unexpected inflation. Even more, TIPS are backed by the U.S. government, so there is almost no chance of default.

This virtually risk-free investment doesn’t come for free, however. Because TIPS provides insurance from unexpected inflation, their interest rates are generally lower than nominal treasury bonds.

Like all bonds issued by the government, your interest from TIPS is taxable under federal income tax but is exempt from state or local income tax.

 

What are I Bonds?

An I Bond, also known as a Series I Savings Bond, is a type of U.S. savings bond issued by the U.S. Department of the Treasury.

I Bonds are non-marketable, interest-bearing US government savings bonds designed to provide investors with a return on their investment while protecting against inflation.

These bonds are considered low-risk investments and are backed by the full faith and credit of the US government.

Like TIPS, I Bonds are inflation-adjusted bonds backed by the U.S. Treasury. I Bonds offer a fixed interest rate and an inflation-adjusted rate, providing a return for up to 30 years.

Like all bonds issued by the government, I Bonds are exempt from state or local income tax, but not federal income taxes.

Related Read: How, When, and Why to Buy I Bonds in 2023

 

TIPS vs I-Bonds: A Closer Look

As mentioned, both TIPS and I Bonds are inflation-adjusted, government-backed securities. In this part of the article, we’ll get more granular, focusing more on the key differences between these two.

Inflation Indexing

I-Bonds and TIPS both protect against inflation, but their approach is different.

TIPS offers protection against inflation by adjusting the principle of security based on inflation. When the principal increases due to inflation, the corresponding interest payment also increases. Likewise, the corresponding interest payment decreases when the principal decreases due to deflation.

The interest rate used to calculate TIPS interest payments remains unchanged during the entire maturity period—the interest payment changes based on the value of the principal.  The principal adjusts on a semi-annual basis based on an index ratio. The index ratio, which is based on the Consumer Price Index from the U.S. Department of Labor, Bureau of Labor Statistics, determines if your TIPS principal value increases or decreases.

I Bonds, on the other hand, use a compound interest rate. A portion of the interest rate remains fixed during the entire maturity period. However, the second interest rate component is linked to the CPI.

This means that I Bonds maintain a constant principal, only increasing due to semi-annual interest payments accumulated, but the interest rate increases and decreases with inflation. Therefore, the interest payments adjust accordingly. It’s also important to note that I Bond’s interest rate can never fall below zero.

 

Marketability

TIPS are highly marketable, while I Bonds are not.

For one, you can’t trade I Bonds on secondary markets. Secondary markets are where investors purchase securities or assets from other investors. I bonds generate interest while you own them, but the interest payments and principal are all paid when you redeem the I bond.

Further, you must wait at least 12 months before trying to redeem your I bond. In addition, if you redeem your I bond sooner than five years of owning it, you’ll pay a penalty of the last three months’ interest.

TIPS, on the other hand, are highly marketable. You can trade tips with other investors before maturity on the secondary market.

Remember that a TIPS bond’s value is subject to market valuation. This valuation is called “mark-to-market,” which is dictated by the prevailing market interest rates and can fluctuate.

TIPS prices are inversely related to the interest rate. Therefore, if the market interest rate is higher than the interest rate on your TIPS, the value will be lower than the adjusted principal value. Likewise, if the market interest rate is lower than the interest rate on your TIPS, the value of your TIPS will be higher than the adjusted principal.

 

Accessibility

Buying I bonds is easier, but you’ll have more ways to buy TIPS.

You can only buy I Bonds via TreasuryDirect.Gov or purchase paper bonds with your tax return through the U.S. Treasury.

In contrast, you can buy TIPS on TreasuryDirect.Gov. You can also buy TIPS on the secondary market with a bank, dealer, or broker via auctions.

You can make non-competitive bids and competitive bids when purchasing TIPS. With non-competitive bids, you accept the discount rate determined at auction. With a non-competitive bid, you are guaranteed to receive the TIPS bill you want and in the total amount. Competitive bills are different. You can specify the discount rate you are willing to accept, and there are three potential options.

  1. The bid is accepted for the total amount if your desired rate is less than the discount rate set by the auction.
  2. The bid is accepted in a partial amount if your bid is equal to the high discount rate.
  3. The bid is rejected if your desired rate is higher than the discount rate set by the auction.
 

 

Purchase Limits

TIPS have more flexible and higher purchasing limits than I bonds.

You can purchase up to $10 Million worth of TIPS at auction. And there are no purchasing limits for TIPS purchases in the secondary market.

In contrast, I bonds have a $15,000 annual purchasing limit per Social Security number. The yearly purchasing limit can be broken down into $10,000 in electronic I Bonds and $5,000 in paper I Bonds. Electronic I bonds can be purchased directly from TreasuryDirect.gov, and paper I Bonds can only be purchased using your Federal Tax Refund each year.

For minimum purchases, TIPS minimum purchase is $100, and all TIPS must be purchased in increments of $100.

I Bonds, however, have a purchase limit of $25. There are no increment requirements for I Bonds purchases, and they can be purchased to the exact penny.

Interest Payments

TIPS issues semi-annual interest payments in the year that they are incurred. These payments are based on the inflation-adjusted principal balance of the bond. These interest payments are calculated using:

  1. The fixed interest rate on your TIPS
  2. The coupon rate on your TIPS
  3. The index ratio following the CPI
  4. The adjusted principal or par value of your TIPS.

The interest rate on a TIPS remains the same for the loan’s maturity. But, this does not mean the interest rate payments remain the same for the loan’s maturity. The interest payments will increase or decrease along with the principal value of your TIPS. The principal value of your TIPS is calculated by multiplying the index ratio and the original principal of your TIPS.

I bonds, on the other hand, earn interest monthly, but the interest is not paid out semi-annually. Instead, the interest is compounded semi-annually, meaning that it is added to the principal balance of the bond every 6 months. This means that the bond grows in value over time, even though the interest is not paid out until the bond matures or is redeemed. Instead, the interest payments are accumulated and paid out either at the maturity of the bond or when the I bond is redeemed.

An I bond’s rate combines two rates: a fixed rate and an inflation rate:

  1. The fixed interest rate remains the same throughout the bond’s life (set at the time of purchasing I bond)
  2. The inflation rate is announced by the Bureau of the Fiscal Service and can change twice a year (May and November) using the Consumer Price Index for All Urban Consumers (CPI-U).

 

Tax Treatment

Tax implications refer to how much you will have to pay on your investments. These tax implications will affect how much your assets are effectively worth on an after-tax basis.

TIPS presents current-year tax issues that I bonds don’t.

TIPS issues semi-annual interest payments based on the interest rate of your TIPS and the published CPI. TIPS owners are required to pay federal income tax on interest payments the year they receive the payments. In addition, TIPS owners must also pay federal income tax on the growth in principal in the year it occurs.

TIPS holders will receive a 1099-INT for the interest payments and a 1099-OID11099-OID2 for the increase or decrease in the securities’ principal value. It’s important to note that, like many other securities, TIPS are exempt from state and local taxes.

I bonds are also subject to federal income taxes and exempt from state and local taxes, similar to TIPS. One major difference is that the federal income taxes on interest payments are paid at the maturity level of the I bond or when the I bond is redeemed, whichever is first.

Another major difference is that I bond holders have the choice of paying federal income taxes on the interest earned on their bonds each year, or deferring paying taxes until the bond matures or is redeemed. Further, I bonds can be a  tax-advantaged savings option for qualified education expenses, whereas TIPS doesn’t provide this feature.

 

Maturity

Maturity is the amount of time that it takes for your investment to be repaid to you – with both principal and interest. The most important consequences of maturity are liquidity and interest rate risk.

Liquidity measures how easy it is for you to access your money without losing some or all of its value.

Maturity levels are important for both I bonds and TIPS, but since I bonds can be redeemed early and TIPS can be sold on the secondary market, there is some flexibility.

TIPS are only sold in electronic form, and they come in maturity levels of 5 years, 10 years, and 30 years. However, you can sell TIPS before maturity on the secondary market. However, sales of TIPS on the secondary market are subject to market valuation and may become more or less valuable than the adjusted principal value depending on the market interest rates and the TIPS interest rate.

I bonds are unique because the full maturity level is 30 years. However, you are only required to hold an I bond for at least one year before you can redeem it. But, all I bonds redeemed before 5 years will experience a penalty of three months interest. With that said, you can redeem an I bond without any penalty at any point after five years.

 

Pricing

TIPS prices are set by the market and by the prevailing interest rates. If the market interest rate at the time of sale is higher than the interest rate on your TIPS, the value of your TIPS will be lower than the adjusted principal value. Likewise, if the market interest rate at the time of sale is lower than the interest rate on your TIPS, the value of your TIPS will be higher than the adjusted principal value.

I bonds don’t have the same price flexibility that TIPS do. The price and the fixed interest rate of I bonds are set by the U.S. Government. Since they can’t be sold on the secondary market, the U.S. Government can set rates as low as possible to balance out the effect of the inflationary portion of the interest rate calculation.

Since TIPS are traded on the secondary market and bid on via auction, they usually yield higher yields and returns than I bonds.

 

IRA Eligibility

Another important consideration is whether you can purchase these bonds in a tax-advantaged account such as an IRA.

TIPS can be purchased and held in your IRA account. You can also purchase funds that hold TIPS within your IRA account.

I bonds, unfortunately, can’t be purchased or held in any tax-advantaged accounts.

This is important because holding these in an IRA can add additional tax benefits to the interest payment you would receive from TIPS.

TIPSI Bonds
Inflation IndexingFlat interest rate – principal adjusts according to inflation factor and interest payments are based on new principalComposite interest rate composed of a flat rate and a portion of the interest rate linked to CPI
MarketabilityCan be sold on the secondary market to other investors before maturityCan’t be sold to other investors. They can only be redeemed with the government
RedemptionAt bond maturity with the government

Can be sold anytime on the secondary market
Minimum of 1 year before you can redeem

Within 5 years, you are subject to a 3-month interest payment penalty

After five years can be redeemed at any time
PricingPrincipal and Interest payments fluctuate with CPIInterest payments fluctuate with CPI
Interest PaymentsSemiannual interest payments are based on the interest rate set at auction. Inflation-adjusted principal is used to calculate the interest amountInterest accrues over the life of the bond and is paid upon redemption
PurchasingTreasuryDirect.Gov Auction and Secondary MarketTreasuryDirect.Gov
Purchasing Limits$10 Million limit on Treasury Direct. No limit on secondary market purchases$15,000 annual limit

$10,000 – electronic

$5,000 -paper
Purchasing minimumsAs low as $100, in increments of $100As low as $25, at any dollar value down to the cent
TaxesSemiannual interest payments and inflation adjustments that increase the principal are subject to federal tax in the year that they occur but are exempt from state and local income taxes.Tax reporting of interest can be deferred until redemption or maturity. Interest is subject to federal income tax but exempt from state and local income taxes.
Lifespan5, 10, and 30 years.30 years.

 

Should I Invest in TIPS or I bonds?

The decision between TIPS and I bonds will depend on the investment characteristics you are looking for. Although they offer inflation protection, they offer this in different ways, each presenting its own investment features.

Income generation is an important consideration. TIPS offers semi-annual interest payments, which means you will generate additional income each year. I bonds, on the other hand, don’t generate yearly income. All interest payments are paid at redemption. If annual income generation is a priority, then I bonds are the better option.

The tax treatment of I bonds and TIPS is also an important consideration. If you are looking to reduce your tax burden in the short term, then I bonds are a better option. On the other hand, if you are looking to distribute your tax burden over the lifespan of the security, then TIPS is a better option.

I bonds don’t generate any tax burden until they are redeemed, where you will pay income tax on all interest payments at the income tax rate when you redeem it and not when you purchase it. This can make I bonds a good option if you are looking to defer tax liability until maturity or redemption and are willing to wait at least one year to redeem your bonds.

TIPS requires you to pay income tax annually on your interest payments at your income tax rate during each respective tax year. In addition, you will be required to pay taxes on any appreciation or depreciation that your TIPS receives due to inflation.

Another important consideration is how much you are looking to invest. These two investments have starkly different purchasing limits. I bonds only offer a $10,000 annual limit on electronic I bonds and a $5,000 annual limit on paper bonds. TIPS doesn’t impose any annual restrictions on purchases directly from the U.S. Treasury, with a maximum purchase amount of $10 Million. In addition, there are no purchase limits on the amount of TIPS you can purchase on the secondary market.

Another important consideration is how long you want to hold your bonds. Both are great options if you can hold your bond until maturity. But, if there is a chance that you will redeem before maturity, then in most cases I bonds have the advantage.

I bonds are easier to redeem at any time as long as you’ve owned them for at least one year. You will pay a penalty if sold within five years of purchase.

While TIPS can sell on the secondary market, the expected interest rates will play a huge role in the price you will receive. Thus, TIPS are ideal if interest rates are expected to fall, but if interest rates are expected to increase, then I bonds are a better option.



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2 thoughts on “TIPS vs I Bond: Which Inflation-Adjusted Bond Is Better?”

  1. Last sentence of 2nd paragraph under “Should I Invest…”–I think you meant to say TIPS.

    Thanks for the very helpful article!

    Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. Excellent description and explanation!

    I own both I bonds and TIPS which I bought through Treasury Direct. Understanding I bonds tax implications and restrictions was pretty straight forward. But, in the case of TIPS, I didn’t fully understand what I was paying yearly on taxes until a couple of years after I bought them. Labeling the TIPS 1099 form “OID” was particularly confusing. Fortunately I eventually figured it out!

    Thank you for such a clear and concise description!

    Reply

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