Advantages and disadvantages of U.S. I-bonds vs. TIPS

Q I am a fan of the safety, predictability and convenience of I-bonds ($500 range). You often recommend TIPS, which I do not understand. Other than the need to hold I-bonds for five years to maximize the interest payment, what are pros and cons of I-bonds vs. TIPS?

JOE, ROCHESTER

A I'm also a fan of I-bonds. A brief definition: TIPS are Treasury Inflation Protected Securities. These inflation-indexed bonds come in five-, 10- and 20-year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. In other words, TIPS are designed to protect the value of an investment dollar against the ravages of inflation.

An additional advantage of TIPS is that they protect against deflation -- a decline in the overall price level of goods and services -- by offering a "deflation floor" that protects principal value during deflation.

The big drawback with TIPS is that Uncle Sam requires owners of TIPS in a taxable account to pay income taxes on the inflation-adjusted gains before getting any of the inflation-adjusted money at maturity. That's why TIPS are best in a tax-sheltered account, like an IRA.

Taxes aren't an issue with I-Savings Bonds, the federal government's other inflation-protected security. These default-free savings bonds allow your money to compound tax-deferred until they are cashed in. There are no commission costs when you buy or sell savings bonds.

You're right, I-bonds redeemed before the five-year mark forfeit the 3 most recent months' interest, but after five years there is no penalty at redemption. You won't get rich saving with I-bonds, but that's not the point of this security. It's designed to make sure that the $1 you set aside today is worth $1 plus some interest five, 10, 15, 20 and 30 years from now. I-bonds stop paying interest after 30 years. Your money will compound after taking inflation into account.

The only drawback to I-bonds is that there are limits to how much you can buy a year. Savers can purchase $10,000 worth a year -- $5,000 online from the Treasury and $5,000 in paper bonds bought at a bank. There are no comparable limits with TIPS.

I-bonds are a cost-effective, safe way to save money. And the Treasury should change the rules and let people invest more of their money in I-bonds.

Chris Farrell is economics editor for American Public Media's "Marketplace Money." Send questions to cfarrell@mpr.org.