Treasury Inflation-Protected Securities are widely advertised as an effective hedge against inflation.

But are they?

There are a number of reasons the answer may be “no.”

CPI may not reflect the inflation you face

The principal of TIPS bonds is adjusted by the CPI. For example, if you buy a TIPS with $100 principal, and the CPI is 4% for the year, the principal of your TIPS will be adjusted by $4 (4% of 100) to become $104.

It might seem like this is a good deal, but the CPI may actually be irrelevant to the price inflation you personally face. In fact, there is no single, “correct”, measure of inflation. The particular price inflation that you face may be more in line with prices as reflected by the PCE, or some other measure of inflation.

Inflation-adjustment isn’t paid out until maturity

Another issue with the above scenario is that TIPS don’t actually pay out the additional amount until the security reaches maturity. So you wouldn’t actually receive cash from the adjusted principal value of the TIPS, the $104, until the security reaches maturity.

Phantom Income Risk

There’s another problem with the inflation-adjusted value of the principal: it hits TIPS holders with an additional tax, even if they receive zero cash.

Consider the example from above: the TIPS with a principal value of $100 and inflation of 4%. The Treasury will adjust your principal value to $104. But the extra $4 counts as taxable income to you in the year it is recorded, even though you don’t get cash then.

Furthermore, you may be taxed even if you never receive a cent of income.

The more money you invest in TIPS, the more you stand to lose to phantom income tax. For example, if you invested $10,000 in TIPS and inflation reached 9% (as it did last year), you stand to be taxed on an additional $9,000 of income which you never received. The additional taxation incurred could wipe out a large fraction, or even all, of the interest that you earn on TIPS, depending on the rate of interest you receive from the securities.

TIPS are complex

TIPS are financially complex instruments, and it can be difficult to understand all the intricacies. We’ve highlighted some of the hesitations with TIPS above, but there are others we haven’t mentioned.

How can you protect yourself?

Given that TIPS are, in many cases, not an effective hedge against inflation, how can you protect yourself from inflation?

You might consider diversifying your assets.

If you or your clients have with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.

For these clients, a 664 Stock Diversification Trust could be their best option.

Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.

If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.

This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation,Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.

Click here for to enter a drawing for a free copy of the book.