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In January 1997, the U.S. Treasury started selling investors Treasury inflation-- protection securities with a term of 10 years. In April of this year, 30-year TIPS were sold, and the Treasury plans to sell 30-year TIPS again in July. TIPS have a guaranteed real rate of return above inflation. This article discusses how the inflation adjustment works for TIPS that are not stripped into separate principal and interest components, and how your clients are taxed on both the stated interest they receive on TIPS and on the inflation adjustment.
Protection of principal. TIPS are designed to protect principal from inflation by indexing the principal to the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U). However, your client will receive at least the original issue price of the TIPS at maturity even if we were to go through a period of deflation.
Example: Assume your client buys $100,000 face amount of 30-year TIPS from the Treasury on their original issue date of July 15, 1998. If he holds them until maturity on July 15, 2028, and the CPI-U at the time of maturity is twice what it was at the time the TIPS were issued, he will receive $200,000 of principal when the TIPS mature.
In the unlikely event that the CPI-U at maturity is only 90 percent of what it was on the issue date, your client will receive the original principal amount of $100,000 at maturity.
The inflation-adjusted principal amount of TIPS for the first day of any month is determined by multiplying the principal amount by a fraction, whose numerator is the value of the CPI-- U for the adjustment date, and whose denominator is the value...