Pssst! We ain't talking waiters or penny stocks here. We're talking about those marketable Treasury securities. You know, TIPS--Treasury Inflation-Protected Securities. I get the question asked often enough as to what exactly it is and how it works.
So, here goes, courtesy of my friends at the Department of the Treasury.
TIPS are marketable Treasury securities paying interest that increases with inflation. The interest is paid semiannually based on the inflation-adjusted principal.
Now, you can buy TIPS as an individual or an institutional investor and you can purchase directly from the Treasury or though your own bank or broker. You buy them in $1,000 increments with 5-, 10-, and 20-year maturities.
What happens is this. Interest payments on TIPS are made twice a year and are linked to the Consumer price Index for Urban Consumers. As measured by the Index, the underlying value of the principal grows at the same rate that the Index rises. Since interest payments are a fixed percentage of the principal, they grow along with the principal.
At maturity (after 5, 20 or 20 years), if inflation has risen and increased the value of the underlying security, then the Treasury pays the owner the higher inflation-adjusted principal. On the other hand, if deflation occurs over the life of the security and the decreases the security's value, then the Treasury pays the owner the original face value of the security.
Two final points to consider. One, TIPS are liquid which means you can buy and sell them in the secondary market before maturity. The value of a security sold in this market is subject to market valuation that may result in either a capital gain or loss, depending on the market prices at the time of the sale.
Secondly, earnings from TIPS are exempt from state and local income taxes. Owners pay federal income tax on interest payments the same year they are received, and on growth in principal in the year it occurs. Actually, TIPS in TreasuryDirect receive two tax statements each year: an IRS Form 1099-INT showing the interest paid and a 1099-OID showing the increase or decrease in the security's principal value.
Oh, by the way, for those who may be sporting a big tax refund out there, you should remember that the maximum purchase amount for TIPS is $5 million for non-competitive bids and 35 percent of the offering amount for competitive bids. Shucks, a max of five million. That hurts.
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