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Possibly the Perfect Place for Emergency Savings

Posted on by troytaft

treasure boxIf you have established a habit of saving and have built up a decent amount of cash, you may start to wonder if there is a way to hold your savings somewhere that won’t leave you exposed to inflation.  There are those who advise you to invest that money, but that’s not really a good idea.  This is the money you intend to use when the unexpected happens.  This means that it can’t be locked up in an investment.  It has to be accessible immediately.  Wouldn’t it be nice if there was an investment that would allow your emergency savings to grow with inflation, but still allow you access that money during an emergency?  It takes a little planning and patience, but there is a way.

Beneficial Features of I Bonds

If you are a “United States person,” you can put your emergency savings in I Bonds.  United States Series I Savings Bonds have some unique features that make them especially attractive for this purpose:

  • I Bond interest is linked to inflation
  • They can be purchased online
  • They can be purchased in small or larger amounts
  • They can be sold anytime after a one year period
  • They keep earning interest for up to 30 years
  • Interest is state-tax free
  • Interest is federal tax deferred

This means that if you start moving a small portion of your emergency savings into I Bonds each year, you could eventually have it all moved over.  Once your entire reserve is in I Bonds, and a year has passed since the final purchase, you can take that money out if you ever have an emergency.  If you don’t it will earn interested at whatever rate necessary to keep up with inflation.

How to Do It

Here’s a scenario that you might adapt to your own situation.  Let’s say that you have a $3000 emergency fund sitting in a money market account at the bank.

First of all, you need to open your account with the United States Treasury.  I have step-by-step instructions on how to do that here.

Then, I would suggest that you save an extra $300.  You would now have $3,300 in emergency savings.  That’s $300 too much.  Take that extra $300 and buy an I Bond.

After a year passes, that bond will be available as emergency savings only it is now probably worth more than $300 because of the inflation adjustments.  Now you are $300 too high in your emergency savings fund again.  This time take $300 out of your money market account and buy an I bond.  Wait for another year.  Now you have over $600 in I bonds and $2,700 in your money market account.  Keep moving $300 each year until all of your emergency savings is in I Bonds.

The Tax Advantages

One of the great things about doing this is that, unlike a money market account, you are not taxed at the local level, and all of your federal taxes are deferred.  You only pay taxes on a savings bond when you cash it out.  This is especially attractive when you find yourself in an emergency.

If your emergency happens to be the loss of a job and you are forced to cash some I Bonds, you will probably be doing it at a lower tax rate.   This may also true if you end up needing it while you are retired.  It’s actually better from a tax point-of-view to take money out of I Bonds when you have less income.

Important Details

If you have a lot of emergency savings, make sure that you don’t attempt to buy more I bonds than you are allowed to buy.  Each person with a Social Security Number is allowed to buy up to $10,000 in I Bonds per year.  If there are two of you, you can both buy $10,000 as long as you both have an account set up.  You can learn more about these bonds in my article: I Just Want to Save My Money.

Another thing to understand, is that if you are forced to sell an I Bond between the second and fifth year after your purchase, you will lose two months of interest when you sell it.  Since you were already losing this money in your money market account, it’s not a big price to pay for protection.  You still get all of your original principal back. After 5 years, all of the interest is yours, no matter when you cash out.

The Next Step

Since you have already proven that you have the discipline to save, you might as well take the next step and start the process of inflation protecting your emergency savings.

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How to Calculate a TIPS Inflation Adjustment

Posted on by troytaft

Calculator Pen TabletTreasury Inflation Protected Securities (TIPS) have the properties of a bond.  Since bonds are just a kind of loan, we can expect to get our money back when the loan period is over.  What makes TIPS especially attractive, however, is that the principal value is adjusted for inflation over time.  This eliminates a bond’s worst enemy.  This valuable feature does have a drawback, though.  There’s more complexity in determining what the value of a TIPS bond is.  Not only are there two ways to consider the value as I discuss in the article: Two Ways to Look at TIPS, the value of the principal is constantly changing.

If you’re a saver like me, you are probably interested in the current value of the principal of your TIPS.  In order to determine that, we need to adjust the bond’s face value by all of the inflation that has been experienced up to now.

Adjusted Principal

The adjusted principal of a TIPS is the amount of money that you would receive if the bond were due today.  You can’t get that money today, but it is the what it would be worth if it were due.  For those of us with a strategy to hold the bond until maturity, this is a meaningful number.  It gives us a view into how much inflation we have been protected from so far.  It is also the number that indicates how much interest you will get on the next coupon.  If our coupon (interest) rate is 1%, that 1% is not calculated on the face value of the bond, but on the adjusted principal.  That means that your interest is going up with inflation too.

Three Step Overview

It’s actually pretty easy to calculate your TIPS current value.  The basic procedure is this:

  1. Get the CUSIP of your TIPS
  2. Go to TreasuryDirect and look up today’s inflation “index ratio” for your specific TIPS.
  3. Multiply the index ratio by the face value of your TIPS.

That’s really all you have to do.  If you hold several different TIPS with different CUSIP numbers, you will need to repeat this process for all of your CUSIP’s.

TIPS CUSIP’s

Every bond that is tracked by the public market has a special identifier called a CUSIP.   There are thousands and thousands of these but they each identify a single bond issue.  When you purchase a TIPS at your brokerage or online you will see your CUSIP for the bond on you “trade confirmation.”  For this example we are going to use the current 10 year TIPS CUSIP and that is: 9128283R9.  This bond was originally issued on 1/18/2018.

Finding your TIPS Index Ratio

Index Ratio Table at TreasuryDirectThe index ratio for a TIPS is a number that you multiply with the face value of your TIPS in order to determine it’s current real value.  TreasuryDirect keeps track of all of these numbers for every TIPS that is currently available on the market.  Every day there is a new index ratio for every bond.  You can look up the index ratios for your TIPS by going to this page on TreasuryDirect:

TIPS/CPI Data Page

When you open this page, you will see all of the CUSIP’s listed for every TIPS that hasn’t matured yet.  Then, you click on your CUSIP number.  When I click on the number 9128283R9, I get a list dates along with some other numbers in a table.  For the sake of my example, lets say that it is April 28th.  To get the Index Ratio, I would go down the list to 4/28/2018 and then go over to the Index Ratio column and see the number: 1.00897.  You will need to get this number for every TIPS that hold.

Calculating the Adjusted TIPS Value

The last step is easy.  For each one of your TIPS that you now have an Index Ratio for, you just take the total face value and multiply it by the Index Ratio.  That is you adjusted principal value.

For my example, let’s say that I have two TIPS bonds with the CUSIP 9128283R9 with an original face value of $1000.  My total face value for both is $2000.   Then multiply that by the Index Ratio I looked up: $2000 x 1.00897.  The resulting current value is: $2,017.94.  This tells me that my money is currently being protected from $17.94 of inflation.

If I had quite a few different TIPS with many different CUSIP’s, this might take a little while to do.  You can make it go a bit faster by getting my free TIPS Tracker Spreadsheet.   I hope to make this process much faster when the new software is released.

So, that’s how you do it.  It’s pretty neat to see your money go up in value, especially on days when the stock market is down.  I urge you to give it a try and experience it for yourself.

I have a spreadsheet that tracks your TIPS and helps you see your inflation protection in action. Learn more here

Copyright © Troy Taft 2018

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Two Ways to Look at TIPS

Posted on by troytaft

Thinking FrogTreasury Inflation Protected Securities (TIPS) protect investors from inflation by automatically adjusting the original face value of the bond for inflation.  What I have discovered is that this feature is used for different purposes by different people.  I tend to use TIPS as a method of saving principal, but there are those who use TIPS as a “hedge” against inflation within a larger portfolio of riskier investments.

The Saver’s View

I discovered that the way that I look at TIPS is much different than the way investors tend to look at them.  Since I look at TIPS as a way to save money for the future, I’m not very concerned about my returns.  I’m just trying to preserve the returns that I have already received.  I’m also trying to make sure that all of this money is available on a specific date.   I also intend for that money to be adjusted for inflation.

The Investor’s View

When investors use TIPS, they are usually trying to make sure that if there is a downturn in other investments that are sensitive to inflation, that they own something that counteracts inflation.  This allows their portfolio to lose less money or perhaps even gain money as a result.

Very Different Intentions

These two perspectives come from two very different intentions on the part of the bond holder.  One person is trying to preserve and the other is seeking opportunity.  This is why I recommend that you divide your money into two parts as I describe in the article: Stressed about Savings? Divide and Conquer!

The Investor’s Bond Market Focus

When we look at TIPS from the perspective of an investor, we are more concerned with counteracting inflation.  This can be done by trading bonds that are sensitive to inflation.  To TIPS traders, the current market value is more interesting than the adjusted principle.  An investor is less likely to hold a TIPS to maturity.  For TIPS investors, TIPS mutual funds or ETF’s may make sense.  Trading TIPS on the secondary market may also be useful.  Bond market traders are also very interested in Yield to Maturity (YTM).  That’s because they are concerned with the return on investment.  Without a good return, it isn’t a very good opportunity.  This may not be a big deal in some investor’s minds because the inflation protection may be worth a loss in that part of their portfolio, however.

The Saver’s Inflation Protection Focus

When we look at TIPS from the preservation of savings point of view,   we aren’t interested in the market value of TIPS.  We are interested in the adjusted principle.  Since we intend to be getting this principal someday when the bond matures, that’s all we really care about.  We are more interested in seeing how well our savings is being protected, rather than seeing our yield to maturity.  As preservers of principle, we are willing to pay some or even all of our yield to make sure that we have our money when we need it.

Taxes

Taxes are a serious problem for both the investor and the saver.  This is one place where the two views tend to come together.  Taxes can make it difficult for an investor by taking money away during a successful time causing the money to not be there for a time when things aren’t so successful.  This makes swings in income even worse.

For savers, taxes can actually cause us to lose money due to inflation as I explain in the article: “Inflation Protection and Taxes.”  Since we don’t make much interest on a savings style investment, taxation can make our preservation costs unpredictable and threaten our attempts to preserve once again.

Be Careful Not to Mix Views

It can really cause you to become paralyzed as to what to do with your money if you flip back and forth between the investing and savings views of looking at TIPS.  I find that it is wise to make a conscience effort to think one way or the other when choosing what to do.   I tend to use them for savings preservation.  I see very little help out there when it comes to looking at these bonds from this perspective.  By viewing TIPS in a way that matches your needs, you will be able to make more confident decisions with them.

I have a spreadsheet that tracks your TIPS and helps you see your inflation protection in action. Learn more here

Copyright © Troy Taft 2018

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Where to Buy TIPS

Posted on by troytaft

Shopping PlateWhere you choose to buy your Treasury Inflation Protected Securities (TIPS) is very important.  As I mentioned in the article: Inflation Protection and Taxes, failing to put your TIPS into a tax advantaged account causes them to shed their inflation protection.  That’s because taxes are assessed as if inflation doesn’t matter.

You can buy Treasury Inflation Protected Securities directly from the United States Treasury at TreasuryDirect.gov.  There are detailed instructions on setting up your TreasuryDirect account in my article: How To Buy an I Bond.  TreasuryDirect accounts are not Roth accounts, though.  That means that you will not be protected from inflation losses due to taxation.

Finding an Online Brokerage Company

Instead of using TreasuryDirect to buy TIPS, I highly recommend that you open a Roth IRA account at an online brokerage company.  I have done a little research for you to make sure that there are some options, but I would not be surprised if there are many more good options.  I came up with four and they are almost the same in what they have to offer as far as TIPS go.

TD Ameritrade

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • Flat $25 trading fee for TIPS at auction
  • Trading fees are based on yield
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

 

E Trade

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

 

Charles Schwab

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

 

Fidelity Investments

  • Roth IRA accounts with no minimum balance
  • Can hold TIPS in the account
  • No trading fees for TIPS
  • Can buy at auction or on secondary market
  • Minimum trade is $1,000

 

Things to Consider

Where you choose to hold your Roth IRA depends on your own needs and preferences.  It may be easiest to open one with a brokerage that you already use for your traditional IRA or 401k.  There are other things to compare as well, such as the fees that will be charged should you choose to leave them, so it’s good to do your homework.

Financial Advisors

If you have an advisor you trust, it might be easy to do it all through them.  Just tell them that you would like to hold your long term savings in TIPS using a Roth IRA and they should be able to take care of it for you.  As you can see, trading in TIPS doesn’t usually cost very much so it shouldn’t cost very much to just have your existing financial advisor do it for you.

If you have an advisor that is unwilling to put you into a Roth IRA or TIPS, I would consider looking for help elsewhere.  TIPS are one of the most secure investments available.  Remember that advisors are supposed to be working for you and they should be looking out for your best interests.

The Fine Print Takes Time

One of the things that really surprised me was the legal paperwork that an account holder is required to understand and agree to before opening an online account.  This creates a time cost that can easily be overlooked. It dwarfs the time it takes to enter your information and set up your account.  The fact that it is in small print and put right at the final button before you open the count should probably be illegal in and of itself, but that’s what we have to deal with right now.

When you click on that little tiny link, it exposes you to as much as 100 pages of legal paperwork that you are required to “read and understand.”  This part of the process took me about a week of reading after I got home from work.

This really hurts, but because I wanted to be honest before God and I could clearly see that I was likely to save thousands of dollars as a result, I eventually got through it.  I didn’t read the documents for all four of these brokerages.  I can only speak for Fidelity.  I did start on Charles Schwab and TD Ameritrade documents.  All of them were pretty difficult.  Schwab’s seemed a bit simpler in language but if I recall, it was about 100 pages printed.

When you read the fine print, you may want to have these links on hand to help you understand what you are reading.  These documents require that you understand jargon in three difficult professions: Tax, Securities and Legal.  Here are some helpful links:

You may even want to “share the pain” with your brokerage representatives.  That’s what I did.  If I got discouraged, I just called them up and told them that I have been going through their legal documents for a few days and I don’t understand “xyz”.

Funding the Account

There are several ways that you can fund an account.  One of the easiest ways would be to roll an existing 401k account into your Roth IRA.  Before you do that, talk to your tax advisor.  In general I think this is a good idea, but your specific situation is important to consider.  Taxes will be required in the year that you do the rollover.  It may be beneficial to do a rollover each year for a few years instead.  Rollovers don’t have a penalty of 10% when you do them before age 59 and a half, but you do have to make sure to specify it as a “Rollover.”  My understanding is that you can only do a certain number of rollovers per year.  Again check with your tax advisor.

You can usually fund an account by linking your checking account to your brokerage account.  This is similar to what you might do when you pay a bill online.

You can also just send a paper check by mail to your brokerage.  They should have a deposit slip that you can get with your account number on it after you set up your account.

The road is quite narrow to protecting your savings from inflation here in the United States.  Even though it’s not easy, it’s worth it to get your brokerage Roth IRA account open and ready to make it possible.

I have a spreadsheet that tracks your TIPS and helps you see your inflation protection in action.  Learn more here

Copyright © Troy Taft 2018

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Inflation Protection and Taxes

Posted on by troytaft

Tax PaperIt’s important to understand that inflation protection is removed when taxes are applied.  Current tax rules disregard inflation, and as a result it’s easy to demonstrate that inflation can cause all of our interest on a TIPS and some of our principle to be lost through taxation alone.

When we consider our inflation adjusted returns, we can easily see that the real tax rate climbs to astronomical levels.  This simple example shows how easy it is for taxes to use up all of our real returns.

A Revealing Example

Let’s consider the effects of taxes on our inflation adjusted gains.  These adjusted gains are what finance professionals call our “real” gains.

Let’s use the actual TIPS that is being offered as I write this and our current inflation rate.  Our current inflation rate is actually 2.2% but we will use 2% make it easier and more conservative.  If you buy a $1000, Ten year TIPS with a 0.5% interest rate and experience inflation that averages about 2% during that time, the overall real gain would be 5% over 10 years and the overall inflation adjustment if it stayed the same during that period would be 20%.

After 10 years, your principle would be adjusted to $1,200 and you would have been paid about $60 in interest.  The problem is that you are not taxed on the just the $60.  The tax rules require that you be taxed on the $60 real gain + the $200 of principle adjustment.  If you are paying taxes at a low 15% rate, the rules say that you must pay 15% of $260 or $39.  Since you really only earned $60 in real value, you will have paid 65% in taxes.

That’s a very high tax rate for sure, but look what would happen if we had an unusual amount of inflation.  This is something we need to consider because our intention is to protect ourselves from both average and unusual changes in inflation.

Let’s change the average inflation to 5%.  After 10 years, your adjusted principle would now be $1500 and your 0.5% interest would be $75.  Your tax on $575 at 15% would now be $86.25.  Since you only really earned $75, taxes will have taken all of your real gain and forced you to take a loss of $11.25 on top of that.  That comes out to be a real interest rate of -0.1125% and a real tax rate of 115%.

In a taxable account, the greater the inflation, the less the protection.  I can’t honestly say that it provides any protection at all because a taxable account amplifies inflation.  It is wrong to assume that our savings is inflation protected just because we hold a TIPS.

One Safe Place

If you open a tax advantaged account such as a 401k or an IRA at a brokerage that allows you to hold TIPS within it, your savings is guaranteed to be protected.  That’s because all growth in a tax advantaged account is either not taxable or tax deferred.  This means that all inflation adjustments to your TIPS principle will only be taxed once, either before you put it into a Roth IRA or 401k or after you take it out of a traditional IRA or 401k.

The combination of a tax advantaged account and TIPS is currently the only option that I am aware of that will guarantee inflation protection to a person attempting to save money in United States.

I Bonds are Only Guaranteed in Certain Cases

I Bonds are tax advantaged in that they are exempt from state and local taxes.  That makes them an even better option than other “safe” investments.  This still does not protect them from a total loss of real gains through federal taxation on inflationary gains.  There is one more advantage though.  If an I Bond is used for tuition, it is tax free and becomes a great way to save for a child’s education.

It is also possible to sell your I bonds at a time in which your taxable income is below your exemption allowance.  If your total income falls below the your permitted exemption, then your I Bonds are tax free for that year.

A Problem for All Investments

It’s very important for all investors to understand that this problem exists outside of TIPS and I Bonds.  As far as I know, all investments have the potential of losing all of their real gains through taxes that are amplified by inflation.  Here’s an explanation of the effects on capital gains:

It’s not just a problem for investors, though.   Inflationary gains are taxed in your very own bank account.  Your interest may be only $1 per year, and you may have actually lost $5 of purchasing power in your account.  You would think that would mean that you lost $4 in purchasing power.  Since you pay taxes on your inflationary gain of $1, it pushes the loss even lower than $4.  Inflation amplifies your taxation because the more inflation there is, the more tax you pay.

Important Things to Remember about Tax Advantaged Accounts

If you have the ability to have 401k, I highly suggest that you do that.  IRAs only allow you to contribute $5,500 per year for those under the age of 50 and $6,500 per year for those over 50.  401k’s allow you to hold far more depending on your income.

If you are a high-income individual.  You currently have no guaranteed protection from inflation for savings that I know of.  It may be a good idea to consider moving your investments overseas.  There are several nations that don’t have capital gains taxes including Mexico and New Zealand.

I have a spreadsheet that tracks your TIPS and helps you see your inflation protection in action.  Learn more here

Copyright © Troy Taft 2018