Are TIPS the answer to my inflation worries?

Umbrella over stacks of coins

Rekindled concerns over inflation -- sparked by the 3.6% cost-of-living adjustment to my 2012 Social Security payments -- have me looking again for government-backed investments designed to guard against that financial scourge.

I start by considering Treasury Inflation-Protected Securities (TIPS).

At first glance, TIPS seem an ideal investment for someone like me, whose focus is on protecting the value of principal and maintaining the purchasing power of income.

Currently offered in 5-, 10- and 30-year maturities, TIPS bear a fixed rate of interest, determined at the time of issuance and payable semiannually until maturity.

Their principal amount, however, is adjusted daily to reflect changes in the Labor Department’s Consumer Price Index (CPI).

Basically, if the CPI goes up, the TIPS principal amount increases proportionately. If it goes down, principal is adjusted downward proportionately.

(There are complexities here that I won’t try to describe.)

At maturity, TIPS pay the greater of their original principal amount or their inflation-adjusted principal amount -- i.e., there’s a floor, but no ceiling.

Thus, TIPS protect both principal and income against inflation. Principal value is sheltered by CPI-based adjustments, income by applying the fixed interest rate to the inflation-adjusted principal amount.

But there’s a catch.

Under the tax code, not only do you have to pay taxes on the semiannual interest payments (which you receive currently), you have to shell out taxes on the amount of any upward principal adjustments made during the year (which aren’t payable until maturity).

I don’t know about other investors, but paying taxes on "phantom income" isn’t for me.

TIPS make more sense for my IRA portfolio, on which I don’t pay taxes right away. My IRA balance represents a shade under 20% of my investment assets.

But this presents an additional complication.

Although you can buy TIPS for a non-IRA account through TreasuryDirect, that system doesn’t have a retirement account feature.

That means buying TIPS for an IRA requires an intermediary, such as a broker (and that can bring attendant headaches, such as "financial advisers," product promotions and fees).

In any event, TIPS have a market value that fluctuates from day to day.

As a hold-to-maturity type of investor, I shouldn’t care -- right?

Well, I do. I hate seeing my nest egg go down in value, even temporarily.

Anyway, to date, I’ve stayed away from TIPS.

But I may reconsider -- if inflation worsens and interest rates improve.

We’ll see.

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