Interest payments are subject to federal income taxes, but not state or local income taxes. Also, any increase in the bond’s principal value is subject to federal income taxes in the year the adjustment is made, even though the funds aren’t received until the bond matures. However, if you hold TIPS in a tax-advantaged account, such as a 401(k) plan or an individual retirement account, you avoid paying income taxes until the funds are withdrawn.

When inflation levels are low, why should you consider TIPS? One reason is that bonds are often purchased for the long term, and over the long term, it is difficult to predict what the inflation rate will be. Owning TIPS removes inflation risk from your bond investment.

To determine whether TIPS are a better alternative for you than other Treasury securities, compare the yield of TIPS to a regular Treasury security of the same maturity. The difference in yield should be compared to your expectations of inflation. If the yield difference is more than expected inflation, then you might not want to purchase the TIPS. If the yield difference is lower than expected inflation, then you might want to purchase the TIPS.

What if we enter a period of deflation? Then your principal value will decrease so that your interest payments will also decrease over time. However, when the bond matures, you still receive the full principal value.