If you are looking to invest in the July 21 auction of a 10-year Treasury Inflation-Protected Security, and you haven’t bought US Savings I Bonds this year, my advice is: Stop right there and read this.

I Bonds are the better investment right now. It’s a slam dunk when you compare an I Bond to a 5-year TIPS. The I Bond pays you the rate of inflation over the next five years, and then you can sell it without penalty. A 5-year TIPS has a real yield of negative 0.620%.

Would you rather have a bond paying the inflation rate, or a 5-year TIPS paying the inflation rate minus 0.62%. Easy choice.

Comparing an I Bond with a 10-year TIPS is a little more complicated.

THE CASE FOR I BONDS

Right now, looking at current yields (July 11), a 10-year TIPS is paying a real return of 0.549%. So with a 10-year TIPS, you get a 0.549% premium over an I Bond. Advantage TIPS.

The problem with that equation is that 10-year TIPS traditionally pay a 1% premium, or more, over I Bonds. There are good reasons for that:

1) I Bonds have a tax advantage. Your interest compounds and your principal base continues to grow over the 30-year life of the the I Bond. But you never have to pay income tax on that growth until you sell the I Bond. A disadvantage of TIPS is that the inflation adjustment to principal is taxable in the year it was earned. So you ‘prepay’ that tax until maturity.

(Both I Bonds and TIPS are protected against state income taxes, by the way.)

2) I Bonds can be sold after five years, with no penalty. (But income tax becomes due when you sell, so the tax advantage disappears at that point.) I Bonds give you flexiblity. If rates are more attractive five years from now, sell and buy the new issue, or a bank CD, or TIPS or just go on a cruise.

3) Record-keeping with I Bonds is much easier. Download the Savings Bond Wizard and enter your info. When the time comes, sell the I Bonds. Pay the tax. Simple.

TIPS are more complicated, and if you ever tried to navigate the TreasuryDirect.gov site to log your interest payments and principal adjustments, you will know what I mean. There are no ‘simple’ reports on TreasuryDirect. You are even on your own to seek out and download tax statements. The government won’t mail them to you.

THE NEGATIVES

I Bonds are pointed at small investors. Each year, you can only buy $5,000 at TreasuryDirect.gov and $5,000 in paper I Bonds, per one Social Security number. That would mean a couple could buy $20,000 a year in I Bonds. Still, the thought of two TreasuryDirect accounts and paper I Bonds sitting in a safe-deposit box … tires me out.

(Update 7/13/11: From Bloomberg: The Treasury Department will halt sales of paper U.S. savings bonds as of January through banks and other financial institutions to reduce costs by about $70 million over the next five years.)

With I Bonds, right now, you are getting the rate of inflation, nothing more. That means you are probably looking at a five-year investment, then selling them, paying the tax and reinvesting into TIPS or better-yielding I Bonds or CDs. They don’t look like a good long-term investment.

THE CONCLUSION

Yes, I Bonds are a flawed investment, but they are also the best super-safe investment around right now. They protect you against inflation. They defer your taxes. They can be sold after five years.

For the super-safe portion of your portfolio, I think the first $5,000 you invest should be in I Bonds (or $10,000 or $20,000 if you are willing to endure the pain of two TreasuryDirect accounts and paper holdings) .

After you do that, go ahead and take a look at the 10-year TIPs being issued July 21.

I’ll probably pass on that one, though.