I Bonds vs TIPS

From Bogleheads

I Bonds vs TIPS compares the similarities and differences between I savings bonds and Treasury Inflation Protected Securities (TIPS). Both instruments offer inflation protection. The Treasury Department has an excellent comparison table, shown below, but their language isn't the easiest to understand. We will elaborate and explain this comparison in more detail.

Comparison of TIPS and Series I Savings Bonds[1]
TIPS I-Bonds
Type of Investment Marketable--can be bought and sold in the secondary securities market Non-marketable--cannot be bought or sold in secondary securities market. Registered in names of individuals and some entities, including trusts, estates, corporations, partnerships, etc.
How to buy At auction through TreasuryDirect, or through banks, brokers, and dealers. Electronic: Anytime online from TreasuryDirect. Paper: available only using your tax refund.
Purchase Limits Auction: Non-competitive bidding:up to $5 million - Competitive bidding - up to 35% of offering amount Electronic: $10,000 per Social Security number per calendar year. Paper (through tax refunds): $5,000 per Social Security number per calendar year.
Par Amount/Face Amount Minimum purchase is $100. Increments of $100. Electronic: Purchased in amounts $25 or more, to the penny. Paper (through tax refunds): Offered in 6 denominations ($50, $100, $200, $500, $1,000, $5,000).
Inflation Indexing Inflation adjustments measured by CPI-U published monthly Semiannual inflation rate (based on CPI-U changes) announced in May and November.
Discounts/ Face Amount Price and interest determined at auction. Electronic I Bonds - purchased in amounts of $25 or more, to the penny. Paper bonds (through tax refunds) issued at face amount (A $100 I-Bond costs $100.)
Earnings Rates Principal increases/decreases with inflation/deflation. Interest calculations are based upon adjusted principal. Fixed interest rate. Earnings rate is a combination of the fixed rate of return, set at the time of purchase, and a variable semiannual inflation rate.
Interest Semiannual interest payments are based on the interest rate set at auction. Inflation-adjusted principal is used to calculate the interest amount Interest accrues over the life of the bond and is paid upon redemption
Tax Issues Semiannual 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, final maturity, or other taxable disposition, whichever occurs first. Interest is subject to federal income tax, but exempt from state and local income taxes. Interest can also be claimed annually.
Life Span TIPS are issued in terms of 5, 10, and 30 years. Earn interest for up to 30 years.
Disposal before maturity Can be sold prior to maturity in the secondary market. Redeemable after 12 months with three months interest penalty. No penalty after 5 years.

Market price fluctuation

After TIPS are issued, they can be bought and sold on the secondary market. If the real interest rate goes down, the previously-issued TIPS with higher real rates go up in value. They can be sold on the secondary market for their true market value. Since there is no secondary market for I-Bonds, they can only be redeemed at accrued value from the U.S. Treasury. If you have high fixed rate I-Bonds, your best option would probably be to hold on to them until maturity. Advantage: TIPS.

On the other hand, if the real interest rate goes up, I-Bonds can be redeemed at accrued value anytime after you've held them for at least 12 months (you'd lose the last three months' interest if redeemed prior to five years), while TIPS go down in value. Advantage: I-Bonds.

Pricing transparency

The TIPS prices (and yields) are set by the market. The I-Bonds fixed rates are set by the U.S. Treasury. As the bond issuer, the U.S. Treasury has an incentive to set the fixed rates on I-Bonds as low as they feel they can to still reach their desired sales goals. Investors do not necessarily get a competitive yield from I-Bonds. Advantage: TIPS.

Purchase limits and fees

There is no practical limit for purchasing TIPS. I-Bonds are limited to $10,000 in TreasuryDirect per Social Security number and $5,000 in paper bonds purchased with IRS tax refund. TIPS can also be purchased through a mutual fund. I-Bonds cannot be bought through a mutual fund. TIPS can be bought in an IRA. I-Bonds cannot be bought in an IRA (they are already tax-deferred). Advantage: TIPS.

There is no fee for purchasing I-Bonds. There is no fee for purchasing TIPS at auction from TreasuryDirect or through certain brokerage firms if the order is placed online. As of May 2008, Fidelity[2] and Schwab[3] charge no fee for auction orders placed online. Vanguard Brokerage Services[4] charges $10 for online auction orders unless you are a Voyager client or higher. All brokers charge a markup for secondary market orders. If you hold a TIPS mutual fund, you will pay a management fee; Vanguard charges 0.20%, and 0.11% for Admiral shares. Advantage: I-Bonds.

Inflation adjustment

I-Bonds are adjusted for inflation every six months. TIPS are adjusted for inflation every day. Advantage: TIPS.

Interest accrual and payments

Interest on I-Bonds is accrued until the bonds are redeemed. TIPS pay out interest every six months. Whether one is better than another depends on whether the investor needs the interest payment or not.

Tax treatment

I-Bonds are tax deferred. Taxes are due in the year in which the I-Bonds are redeemed, unless the investor elects to pay tax on the interests every year. If the I-Bonds are used to pay educational expenses, the interest may be fully or partially tax-free, depending on your income[5]. Interest payments and inflation adjustments on TIPS are taxable every year. For this reason, it's often suggested that investors hold TIPS in a tax-deferred account. There is no practical way to hold I-Bonds in a tax deferred account. Advantage: I-Bonds.

A note on negative real rates

The fixed rate component of both TIPS and I-Bonds is based on real interest rates, which are normally positive. Real interest rates can sometimes go negative, however. When real interest rates are negative, the fixed rate on TIPS is also negative.

However, the fixed rate component of the I-Bond has a floor at 0% and cannot go negative. This is a large advantage of I-Bonds when purchasing during a period of negative real interest rates. You can view current levels of real interest rates here. Advantage: I-Bonds