TIPS are a special type of Treasury note and bond. Interest is paid every six months and the payment of principal occurs at maturity as with most other types of notes and bonds. But, with TIPS, interest and redemption payments are adjusted for inflation as measured by the CPI-U. At maturity, the TIPS note/bond is redeemed at its inflation-adjusted principal amount or its original par value, whichever is greater. Also, as with most other notes/bonds, TIPS pay a fixed rate of interest. However, the fixed rate is applied to the inflation-adjusted principal, and not the par amount of the security. As a result, if inflation occurs throughout the life of the security, each interest payment will be greater than the previous one.
TIPS are exempt from state income tax and subject to federal income tax. In any year when the principal grows, the increase is taxable in that year, even though you will not receive the inflation-adjusted principal until the security matures. Because of this, TIPS should be held in a tax-deferred account, rather than in a taxable account.
