If you buy and hold Treasury Inflation-Protected Securities at TreasuryDirect, as I do, you’re violating a conventional wisdom rule of investing: Don’t hold TIPS in a taxable account.
I disagree with that conventional wisdom, more or less, but mainly because holding TIPS in a tax-deferred account generally means buying TIPS mutual funds instead of the actual issues. Or, a brokerage like Vanguard or Fidelity will allow you to buy TIPS at auction and hold them in an IRA account. But then you end up trying to find ways to invest and/or reinvest cash distributions and maturities.
So while holding TIPS in a tax-deferred account is preferable, I say holding them as a taxable investment at TreasuryDirect is also acceptable as part of your overall fixed-income asset allocation.
But, TIPS are different. TreasuryDirect, I have to say, is absolutely not user friendly. While every brokerage and investment firm on Earth mails you tax forms (or at least notifies you they are ready to download), TreasuryDirect does nothing. You will get nothing in the mail, you will not receive an e-mail alert. You are expected to remember to log in to TreasuryDirect.gov and retrieve your tax forms:
- Form 1099-INT shows the sum of the semiannual interest payments made in a given year. This income is generated by the TIPS’ coupon rate, and is taxable at the federal level but tax-fee at the state.
- Form 1099-OID shows the amount by which the principal of your TIPS increased due to inflation or decreased due to deflation. Increases in principal are taxable for the year in which they occur, even if your TIPS hasn’t matured, so you haven’t yet received a payment of principal.
So 1) you find your own tax forms, and 2) you print them and 3) these Treasury forms are like no other you’ll see from Vanguard or Merrill Lynch. They just list the amounts paid for each TIPS and give you a total. At the bottom are some definitions for IRS box numbers that are never specified on the form itself. Very weird. The Treasury could do better.
Form 1099-OID is the one behind the conventional wisdom to invest in TIPS in tax-deferred accounts. You are paying tax on money you have not yet received. This is often called ‘phantom income.’ However, if you have a Total Bond Fund or GNMA Fund in a taxable account and reinvest the dividends, or have a 5-year CD at a bank and are reinvesting interest, you are doing exactly the same thing. You are paying tax on money you have not yet received.
(Read this for a scholarly treatise, including incomprehensible formulas, debunking the conventional wisdom about holding TIPS in a taxable account.)
When the TIPS matures, here’s the good thing: You don’t owe any tax on the accumulated inflation-adjusted principal, because you’ve prepaid it. So if you bought a $10,000 10-year TIPS in 2010 and it matures in 2020 with a 23% inflation boost to principal, you get $12,300 and you owe no tax. This could work in your favor for allocating spending money in retirement.
But the dreaded 1099-OID is the big reason I Bonds are preferable to TIPS, especially when they offer a favorable return, as they do now well up the maturity ladder. With I Bonds, your principal keeps increasing by the rate of inflation plus the base interest rate (which is currently zero for new I Bonds). You owe no tax on I Bonds until you redeem them, and you can hold them for 5 to 30 years before redeeming without any penalty.
I Bonds also offer a strategic advantage for retirement spending money because you could redeem them gradually to space out the tax owed. They are the ultimately flexible super-safe investment: 1) inflation protected, 2) deflation protected, 3) tax protected and 4) you choose the maturity date.
Big question mark over 30-year TIPS. If you buy a 30-year TIPS at auction – your next chance is a reissue on June 20, 2013 – you will get a coupon rate of about 0.625%. That means if you bought $10,000 in June, you’d get about $62.50 in annual interest, but that would grow as the principal grows with inflation.
However … let’s say inflation averages 3% in coming years. Your taxable adjustment to principal would be $300 a year, and it would also grow as your principal rises.
In this example, you’d owe federal taxes on $362.50, resulting in a tax of $100 or more. But you got only $62.50 in actual interest payments. So this TIPS will have a negative cash flow for 30 years.
The big question is: Will you be alive in 30 years? If not, you will never see the money that you are paying tax on. That makes no sense.
If you buy a 30-year TIPS and plan to hold to maturity, make sure you live 30 years.
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Pam, if you bought that 10-year TIPS at auction 10 years ago, the discount was probably very small. TIPS have coupon rates that mark up in increments of 0.125% and the auction yield can be slightly higher, so the buyer gets a slight discount. When a TIPS reopens, the variance can be wider, since the coupon rate is already set, and the buyer can get a bigger discount or pay a premium.
If you paid $10,000 for that TIPS 10 years ago and got about $12,300 at maturity, that extra $2,300 was interest and you’ve already paid taxes on that. So no taxes are owed.
Anyway, I am not a tax expert, but I can say I have never reported a capital gain or loss on any maturing TIPS, so far. The small discounts and premiums have probably balanced out anyway. Some TIPS auctioned from 2011 to 2013 had very high premiums because of steeply declining yields or negative yields at auction. Buyers should plan on taking a capital loss when those TIPS mature, because the amount can be significant.
I held a 10-years TIPS to maturity, puchased at a discount above the de minimus amount, and did not receive a 1099-B. Do I need to report this matured TIPS note on my tax return? Would I have a gain or loss, or just need to report the same amount for proceeds and basis? Thank you.
Jimbo, it would be interesting to know if TreasuryDirect has had many outright fraud cases. The fraudster would need access to your TreasuryDirect account and your bank account where the money would be deposited. I am sure it has happened. It probably also happened with paper I Bonds and someone assuming an identity.
Jimbo, I have done some security thinking re. TreasuryDirect accounts also. An account is in your name, on the books of the U.S. Treasury. They told me verbally that their security has been tight, to date. I ‘presume to suppose’ that the UST has SO much rep. to lose … That it won’t happen here!?
Well, I had fallen in love with iBonds until someone pointed-out that there are no laws currently in place to protect you from fraud. If you have money in a bank and pay attention to your accounts, the loss you can incur is severely limited (a few hundred bucks at most). If you have money in a Treasury Direct account with the US Government, those consumer protections don’t apply. So, I’ll be cooling my jets with regards to further investments in iBonds. One of these days I’m going to get off my duff and start putting pressure on my elected representatives to rectify this situation. But right now, I’m still working. So, I don’t need the additional aggravation that goes with getting involved in politics. I did that when I was in college with mixed results.
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Thanks. It seems I have more homework to do.
From that Street.com discussion:
“With a taxable bond bought at a premium, the investor can choose whether to amortize the premium. To amortize a premium is simply to adjust your cost basis in the bond downward by a certain amount each year, such that at maturity, it is equal to par. If you amortize the premium, then each year you can deduct that year’s amortized portion of the premium from your income. …
“If you don’t amortize the premium, then when the bond matures or you sell it for a lower price than you paid for it, you can declare the difference between the price you paid and what you received as a capital loss.”
This will be free of details, you can look them up. It is the way I have done it, which is generally the best way for the taxpayer, as I understand.
You bought the note at a premium price.
Over the life of the note in your hands, you amortize the premium — which reduces the taxable interest you report each year.
You report OID inflation-adjustment as usual each year.
You do all the above for the year of maturity, also. Then you have ZERO capital gain/loss, which is NOT reportable..
Bill, you should be able to look back and see what you originally paid for the TIPS, such as finding the bank draft that paid for it. In the ‘old’ days, before negative yields, what you paid and the par value were very close. Today is another story, so it’s important to log what you are paying for a TIPS: $10,500 for $10,000 par, for example. When the TIPS matures, that $500 should be a long-term capital loss. (But again, I am not a tax expert.)
Here is a discussion of this issue on TheStreet.com:
TreasuryDirect also gives you, in the same package, a 1099-B. This lists all of the notes and bonds that matured during the year. It gives no value for the basis, though it sure would be nice if they did. Next year, 2013, is the first time one of my TIPS will mature. Any idea how to calculate the capital gain/loss on it? When the first batch of 5-yr TIPS with negative yield mature, in April 2016, any idea how we calculate the capital loss?
Indeed, TIPS are different — but well worth the thinking, I would claim. That includes the ‘trouble’ of doing your own thinking. Remember, the ‘system’ rarely shows you these inflation-adjusted asset price histories
which are obviously VERY instructive! Note that an investment giving 0% real return of principal in these charts has identical vertical axis values for its start and finish.
David. sorry it’s taken so long to refer to your post! For TIPS, the not currently received but currently taxed inflation adjustments ARE automatically ‘reinvested’ at 0% real return of principal.
Referring again to the charts at the URL, there are PLENTY of start/finish pairings WORSE than 0% real return of principal. Timing WAS overwhelmingly important, seldom seen or not!
If an investor was “buying the Dow” by dollar cost averaging during the 1920s, they would not have recovered until the 1950s. If one was “buying the Dow” by dollar cost averaging during the 1960s, one would not have recovered their investment until the 1990s.
I had heard some skepticism about the return of the stock market versus inflation before, but that site you found just nails it. Thanks, Ed. I feel much better now. Har har
Thomas, Thank you. I’m pointing out these real histories for the common good, glad to have helped you.
As I wrote at the top of the URL: “The public be suckered” is both this track record, and keeping it unseen.
As I have written elsewhere: I am certain that it is a far, far better thing for our nation if the people have their heads OUT of their fuming darknesses.
Consequences, I claim, include: the MAIN ENABLER of sizable asset price bubbles is keeping the real price histories out of sight!
It occurred to me that the Dow Jones Industrial Average does not account for dividends. If the DJIA stocks had an average dividend yield of 2%, then the inflation-adjusted gains would be a bit better. Thus, an investor would have been doubling their buying power in those thirty year periods that I just described, instead of just catching up with inflation. I don’t know what the historical rates for dividend yields are, so I am just estimating the results.
Different indices count dividends differently: http://www.ehow.com/about_7510723_dividends-included-stock-index.html
Books I have read by Professor Zvi Bodie have made me way wary of claims that the stock market always gains if one holds long enough. That thesis from the 1990s called “Dow 36,000” is truly daff. You are right to be skeptical, Ed!