If you’re concerned about inflation. Uncle Sam offers an investment that protects you from the vagaries of the Consumer Price Index. Treasury Inflation-Protected Securities, or TIPS, are a safe investment and are backed by the U.S. government. Here is what you need to know about this investment:

How TIPS Work

TIPS can help preserve wealth

TIPS bonds are sold in maturity rates of 5, 10, 20, or 30 years. They pay a fixed rate of interest, but the amount of your principal can fluctuate with inflation. Basically, twice a year, the government uses the Consumer Price Index to readjust the value of your TIPS. For example, your $1000 TIPS bond will be worth $1030 with 3% inflation. This means you will maintain the same buying power with your principal, even with spikes in inflation.

Even though deflation can also have a negative impact on your TIPS investment, there is a floor below which your principal cannot fall. The same $1000 bond will not fall below the original principal value of $1000, even if prices fall by a significant amount.

Income and Taxes

Interest is paid on these investments every six months. Annual inflationary increases to the principal are also considered to be income, which means that you will owe federal taxes on both your interest income and your inflationary increases. However, there are no state or local taxes on these gains. Because you will owe federal taxes on your income from TIPS, it makes the most sense to hold them in an IRA or other tax-advantaged account.

Investing in TIPS

There are several options for investors interested in Treasury Inflation-Protected Securities. If you would like to purchase your investment directly from the government, you can visit TreasuryDirect.gov. The benefit of this method is that you will not pay commission or management fee for your purchase. However, direct ownership can also have pitfalls, including having to personally deal with reinvesting earnings, and paying taxes on phantom income (that is, money you don’t receive that represents gains in your principal).

Investing in TIPS through a mutual fund will allow you to automate much of your investment, although you will have to pay a commission and an on-going management fee. However, automatically purchasing more shares with your earnings, and having your principal gain distributed to you (as funds are required to do by law), which means you will have the cash on hand to pay your taxes, will be worth the extra money for many investors.

When to Invest

The best time to invest in TIPS is when inflation is about to rise. Since you earn interest based upon your principal amount, rising inflation means you have more principal to earn interest on. However, because TIPS protect your investment against inflation, they can be a smart addition to any portfolio, no matter what is happening in the market.

The Bottom Line

TIPS offers investors a safe investment with the potential for modest return. While it would be a mistake to only invest in Treasury Inflation-Protected Securities, they provide a good core strategy for any diverse investment portfolio.