Inflation bonds differ from standard bonds in that they offer not only a fixed rate of return, but also an inflation rate, an amount that adjusts every six months depending on the Consumer Price Index. Why is this beneficial to investors? Simply put, as inflation continues to rise, the interest gathered from a fixed-amount bond is not worth as much as it was five or ten years ago. An added bonus: inflation bonds are exempt from state and local taxes, as well as federal taxes, when the earnings are used for tuition and college fees.

Inflation bonds are typically offered directly from the United States Treasury. The Treasury offers two types of these bonds: the Treasury Inflation Protected Security (TIP) and the I Bond. The former is sold at auction and available in 10- or 30-year maturities. The latter can be redeemed after six months.

What are the downsides of inflation bonds? First, they are subject to market fluctuations. Second, their relatively low liquidity makes them an unsuitable option for those looking for short-term investments. Finally, the bondholder must pay federal taxes each year on both the fixed and inflated interest. Because of this, some experts recommend holding the bond in a tax-exempt account.

So who should invest in inflation bonds? Anyone who is looking for a stable long-term investment can benefit from this purchase. They are particularly suitable for couples or individuals looking to supplement their retirement savings, as well as for parents looking to put money aside for their children's college. The TIP bond would be an appropriate choice for either of these two scenarios: a 30-year investment for the potential retiree, and a 10-year investment for the parent.

For other investment plans, the I bond offers more flexibility. They hold the advantage of never decreasing in value, while the value of the TIP bond can vary. I bonds can be redeemed after five years with no penalty, opening up more options for the short-term investor. They can be bought in denominations of $50, $75, $100, $200, $500, $1000 and $10,000.

Overall, either type of inflation bond may be a good choice for someone looking to make a long-term investment, and wanting to protect that investment from rising inflation rates. Before making an extended commitment, however, one should be well-informed as to the risks and rewards associated with the different types of bonds, and chose the option best suited to his or her financial needs.

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