We are nearing the final days of tax season, so I am reposting a blog I wrote back on March 28, 2013, on investing in TIPS in a taxable account. In my case, my portfolio allocation works better that way, but I still contend it isn’t a horrible strategy. You prepay the taxes (horrors!) but get the full payout in retirement, no taxes due. The only problem is the 1099-OID tax form, which TreasuryDirect barely hints is available and makes as cryptic as possible. It is unlike any tax form provided by any investment company in the nation.
And so here is my post from 2013, minus some outdated stuff about 3o-year TIPS:
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 for seven years up the maturity ladder. With I Bonds, your principal keeps increasing by the rate of inflation plus the base interest rate (which is currently 0.2% 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. (This paragraph was updated for 2014.)
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.
Lynne, I am not a tax expert, and I have never taken a capital loss or gain on a TIPS purchase held to maturity. Most of my purchase prices for matured TIPS were close to par value. But I have a couple in my ladder now that I did pay a premium on, and I do plan on taking a small capital loss on those when they mature. That is logical because you have been paying income taxes on the interest, which is based on the coupon rate, and you paid a premium to get that coupon rate. So you paid taxes on interest you never actually earned.
In this case, are the taxes saved on the capital loss, saved at the capital gains rate? The taxes paid on the TIPS (1099-INT and 1099-OID) are at the effective income tax rate, typically higher than the capital gains rate. For this reason, would it be better to amortize the purchase premium?
Better tax-wise but torture to compute correctly per the regs.
In 2013 I made two ten year TIPS purchases, both at a premium price. This year I paid the interest listed on the 1099 and the OID. I did not amortize the premium. When the TIPS mature do I claim a capital loss between what I paid for the TIPS and the par price? Or would it be better to start amortizing the premium at tax time in 2014 and continue to do so each year?
Fred, I have done a couple of financial planning exercises with Vanguard. Both times, the first wave suggestion was to sell the TIPS to invest (of course) in Vanguard funds. I said,’That’s not my plan.’ To Vanguard’s credit, both planners said, ‘No problem, we see your logic.’ There are NO advocates for buying TIPS directly and holding them to maturity, because there is no middleman, no (even slight) management fee. It’s just a part of a bigger financial plan. Good companies like Vanguard also play a role.
Well the conventional wisdom on holding TIPS in a taxable account is really the Wall Street “wisdom” in my mind- they’ll say anything to keep you in their clutches. I too hold the bulk of my TIPS in a taxable account and since they are laddered I don’t see what the big problem is, for now anyway. If we had really high inflation as in the Seventies you might have a cash flow problem, but then you would be damned glad you had them too. Very interesting article you referenced there.
Whenever I do my taxes I think of Gregory Baer (a former Treasury official- Clinton era) and his book THE GREAT MUTUAL FUND TRAP. He castigates as foolish people who buy their Treasuries through mutual funds when they could use Treasury Direct. I don’t imagine he does his own tax preparation though. Fred