Fix What I Have,
Thanks for the recent piece that was very helpful in explaining how to invest in Treasury inflation-protected securities (TIPS).
My wife and I have a lot of money saved up and put in Series I bonds. They are simple, which is a good thing, but it also has some bad points. It doesn’t worry me that I have to hold them for five years before I can leave without being punished. That being said, you are correct that each Social Security number can only invest $10,000 per year. Also, Series I bonds don’t trade on the open market, so I’m never sure if the government set the fixed-rate part of I bonds fairly when I buy them.
I have thought about buying TIPS before, but I can’t get my mind around it.
- In theory, it’s fine to buy a TIPS fund, but I’d rather hold on to my bonds until they mature so I don’t have to worry about the fund price going up and down when interest rates change.
- You can buy TIPS for a tax-deferred account if you want to, but the account might not have cash on hand.
- If you buy TIPS in an account that doesn’t delay taxes and plan to hold on to them until they mature, you will still have to pay taxes every year on the change in the nominal value of the bonds, even if you haven’t sold any of them. This is because you want to avoid inflation as much as possible. That is, taxable “events” happen every year, even if you hold until maturity. Even if you get income from the bonds, that doesn’t change the amount of the tax you have to pay. There are times when inflation is very high and you need to get extra money to pay your taxes.
Is my understanding correct? Is there any way around this?
How are you?
Your knowledge of TIPS and the tax problems that come up if you hold them outside of an IRA-type account is spot on. You can either go into the situation with an open mind or stay away from it.
David Dubofsky, a former business professor and CFA who wrote an introduction to fixed-income investments and whose advice I used in my earlier TIPS piece, said, “If you don’t understand the quirks, you shouldn’t buy them.” They have a lot of holes that you won’t see unless you’ve been investing in bonds for a while.
TIPS are a product of the Treasury that are meant to cover both principal and inflation. There is a set rate that is given to you when you buy the bond, and then there is an extra amount that is added every six months to account for inflation. For the most part, the two rates together are as good as or better than the rates on other fixed-income products that are similar, such as CDs, money markets, other Treasury bonds, and even your favorite Series I bonds.
When comparing TIPS and I bonds, which are the most similar of these investments, they’re about even when it comes to real rates and inflation rates. However, TIPS are more flexible because you can buy and sell them on the secondary market through brokerages, while you can only buy $10,000 worth of I bonds each year.
For this reason, you shouldn’t avoid TIPS just because of taxes if you’re a senior who wants to protect yourself from inflation and have a steady income. You should try to figure out what’s going on and work with it instead of against it.
Location worries about assets
It’s most important where you hold TIPS. The author of the primer says, “If you want them, buy newly issued individual TIPS securities in a tax-deferred account such as an IRA.” You won’t have to worry about the bonds’ tax effects after that. When you take money out of an IRA, the only thing you have to think about is the income tax you have to pay.
TIPS can make paper gains and losses before maturity, which you have to account for in your taxes as you go. If you hold them in a normal taxable account, on the other hand, you’ll run into the problem you pointed out. You could hold a ladder of TIPS in your retirement account for 20 years or even longer. That’s a lot of years where you might have to pay taxes on gains every year. Most people call this a “phantom tax” because it’s a tax on money you haven’t even gotten yet. Dubofsky calls it “phony” income.
Erik Bronnenkant, head of tax at Edelman Financial Engines, said, “Taxpayers don’t like paying taxes on income they don’t get anything from.”
One part of the return for TIPS is the interest received, and the other part is the price gain on the principal. This makes things more complicated. When the year is over, you’ll get a 1099-INT form that lists all the cash interest you earned during the tax year. You’ll have to pay federal income tax on that amount, but as with most Treasury goods, you won’t have to pay state or local taxes on it.
You will also get a 1099-OID, which stands for “original issue discount,” for the inflation-component part of TIPS. This shows the “increase or decrease in the security’s principal value,” according to the Treasury. Note: If you hold TIPS at TreasuryDirect.gov instead of in an IRA or a taxable trading account, you’ll need to go to your account page to find your statement.
He said, “Let’s say inflation was 2% for the first year you held $100,000 in TIPS. You would get cash interest and a statement for $2,000 on top of that.”
If prices have dropped in the past year and your TIPS are worth less than what you paid for them, you could get a negative amount on your 1099-OID. But you can’t lose money on directly bought TIPS if you hold on to them until they mature; you’ll get at least your capital back. Lost money can be locked in if you buy on the secondary market or sell before the due date.
You won’t have to pay more in taxes if you pay for TIPS over time instead of all at once like you would with other investments. When you cash in the bond at the end of its term, you will not be taxed again on the taxes you paid along the way. You can leave with the capital and gain, and the taxes that are due at the end won’t take anything away from it. It really comes down to how much papers you can handle.
Bronnenkant said, “Some people who invest in TIPS only think about them in terms of a retirement account to avoid OID-related problems.” You can plan your approach around keeping TIPS in a taxable brokerage account and paying the ongoing tax. This way, you’ll know how much money you’ll have in retirement when the bonds mature. This might help you understand how to build a TIPS ladder so that you have cash each year to spend in retirement.
Bronnenkant said it would depend on what kind of investments you want to make. You could put your money in a regular Treasury bond with a fixed rate for five years instead, and count on the income. You could also set up something similar with business bonds, though the principal would not be as safe. You can also use I ties.
Bronnenkant’s TIPS advice for you is to think about your goals first: “What’s more important?” Is it to protect against inflation or to make taxes easier?”
