I-bonds vs TIPS

Question: I have the opportunity to buy $10,000 worth of I-bonds this year, or $10,000 worth of TIPS in an IRA account. Which is better--or is it more or less the same risk and return? Is it better to by a TIPS bond directly, or in a bond fund?

PS: Your book was great and I enjoy hearing you on public radio. Ken, Swarthmore, PA

Answer: Thanks a lot. Just a quick definition: TIPS are Treasury Inflation Protected Securities. These inflation-indexed bonds come in 5, 10 and 20 year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. TIPS are designed to protect the value of an investment dollar against the ravages of inflation (as measured by the CPI). Uncle Sam levies income taxes on the inflation-adjusted gains before you get any of the inflation-adjusted money at maturity. That's why you're right to see TIPS as the better investment in a tax-sheltered account, like your IRA.

Taxes aren't an issue with I-Bonds, a savings bond that is the federal government's other inflation-protected security. There are no commission costs when you buy or sell savings bonds, and your savings compound tax deferred. I-bonds redeemed before the 5 year mark forfeit the 3 most recent months' interest, but after 5 years that there is no penalty at redemption.

The key to answering this question is when do you need the money? It's advantage I-bond if you might tap the savings at some point in the future but before retirement. You can sell the I-bonds without incurring a penalty even if you're under 59 ½. You just pay Uncle Sam whatever you owe in taxes after the sale (and I'm assuming you'll own them for 5 years).

In sharp contrast, if you buy TIPS in your IRA, you can't get at that money without paying taxes on it plus a 10% early withdrawal penalty if you're under 59 ½. You'll have to pay a broker a fee to purchase the TIPS for you in an IRA (although the charge should be very small.) If you're okay with the extra work and monitoring the bonds then I would lean slightly toward owning individual TIPS. This way you know what you have and when the bond will mature. You could care less about fluctuations in the bond market. But a very low cost TIPS mutual fund is just fine for those who favor its convenience.

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Chris Farrell is the economics editor of Marketplace Money.
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I was actually thinking of sending a similar question about I-Bonds earlier today. Rather than risk ending up with three consecutive I-Bond questions, I'll just post it here..:

I'm saving for an eventual first-home downpayment, which I don't plan to cash out for another 3-6 years. My emergency fund, which is stored in a 3% online savings account, is now quite flush, so I'm looking for somewhere with a higher rate to put this additional savings.
Given that timeframe, and therefore with a high likelihood of eating 3 months interest, are I-Bonds still a good choice? I find the relatively high return for little risk to be very appealing, but I don't know if there are other options out there which would better fit my situation.
It seems that even after including the potential interest penalty, the current I-Bond rates are still way better than what's available in CDs, money market accounts, and even other Treasury products. And once that first year is up, I can cash out whenever I feel it's a good time to buy.

PS: Thanks for the tips on Marketplace Money about sticking to low-fee index funds for 401k's. I started an account since Jan 2008 (and I'm not retiring for 40 years), so it wasn't yet a big deal to switch away from the higher-fee managed funds I'd been using before. It's even possible that I came out a little ahead, since the prior funds weren't all-stock.

I see the advantage to I-bonds if you need the money sooner, but if you don't need to get at the money, why does the advantage go to TIPS?

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