Banks have begun to offer inflation-protected certificates of deposit, with a variable yield that’s adjusted to keep up with inflation, as calculated by the Consumer Price Index. The fixed rate of the CD, meanwhile, is paid on the adjusted value every six months. These CDs are insured by the FDIC up to $100,000.
Say you invest $1,000 in an inflation-adjusted CD paying 2 percent. On the first coupon payment date, six months later, inflation has been 1 percent. The CD’s base increases by 1 percent, to $1,010, and the interest payment is $10.10 ($1,010 times 1/2 year times 2 percent).
The higher the inflation rate, the higher the return on these CDs. However, the inflation adjustments to the base amount are taxable in the year in which such adjustments occur even though the investor won’t receive the additional interest until the CD matures. For this reason, it may be best to hold such CDs in a tax-deferred account such as a 401(k) or an IRA.