The temptation is to think of inflation-adjusted bonds--- like I Savings Bonds--- as a form of magic. The offer certainly glimmers. Current I Savings Bonds offer a total return of 4.66 percent. In a yield starved world, that's enough to crush most competition.

The return is based on a fixed return of 1.10 percent plus an adjustment for inflation, currently annualized at 3.54 percent.

Unfortunately, the return is pre-tax and the same government that believes we should pay taxes on inflation gains elsewhere wants us to pay taxes on inflation here as well--- so the full 4.66 percent return on I Savings bonds is taxed. TIPS (Treasury inflation protected securities) receive similar tax treatment.

One kind thought here is that we should be grateful for tax consistency. We should appreciate its uniqueness--- after all, the abomination that currently poses as our tax code provides all of us with no consistency beyond the certainty of future change.

What we need to do is understand what taxes can do to inflation-protected returns.

If you are in the 15 percent tax bracket and own I Savings Bonds, our government will claim 0.70 percentage points of your 1.10 percentage point real return for taxes, leaving you with a net real return of 0.40 percent.   This is what the vast majority of people who buy these securities would receive. Remember, the new tax law also increases the size of the 15 percent tax bracket for couples to twice that of the 15 percent bracket for singles, or $56,800. Add $6,100 for two personal exemptions and $9,500 for the standard deduction and your adjusted gross income will have to exceed $72,400 before you're in the 25 percent bracket. (The comparable figure for single returns is $36,200.)

Step into the 25 percent tax bracket and inflation adjusted investing turns slightly negative. Subtract 1.16 percentage points in taxes (.25 x 4.66) from your real return of 1.10 percentage points and your after-tax, after-inflation return is minus 0.06 percent.

Not much to crow about.

Needless to say, those in higher tax brackets will suffer more. The net real return for an investor in the 35 percent tax bracket is a purchasing power loss of 0.53 percentage points.

The real problem for investors in all tax brackets, however, is that your after-tax return will shrink dramatically if the rate of inflation increases. Suppose, for instance, you bought an I Savings bond today and inflation over the next ten years equaled the 8.1 percent rate that prevailed from 1971 to 1980? Then your total return would be 9.2 percent (1.1+8.1).

  But you would lose 1.38 percent (0.15x 9.2) to federal income taxes, netting you a purchasing power loss of 0.28 percentage points a year. Investors in the 25 percent tax bracket would lose 1.2 percent a year of purchasing power.

This isn't unique to inflation-adjusted bonds, of course. Traditional fixed income obligations of all kinds suffer the same fate--- the greater your need for the return of your money (not the return on your money), the greater the odds your investment will lose purchasing power.

Does this mean we should avoid I Savings Bonds even though they are superior to virtually any secure obligation in the fixed income world?


Just remember the caveat: taxes matter.

Can we do better?

Some can. The most powerful fixed income investment you can make is to eliminate virtually any debt you have, including most home mortgages.

That will keep most people busy a while.

Related columns:

The Sunday column on I Savings Bonds:

Information on I bonds