Letters to the editor

TIPS and taxable (non-qualified) accounts

I received this letter to the editor from Greg.

Subject: TIPS and taxable (non-qualified) accounts

Excellent site.

Could you please comment on TIPS in a taxable account? Scott Burns recommends I Savings Bonds for non-qualified and TIPS for qualified (IRA) accounts because of tax treatment.

Also, would it possible for me to pay a fee to get more detailed assistance on retirement saving?

Thanks!!!

Greg

HERE IS MY RESPONSE:

Thanks for your very kind words.

TIPS are treated as other Treasuries in a taxable account with one unpleasant feature: all inflation adjustments to principal are treated as current interest. Taxes are due every year. There are no deferrals.

If I understand correctly, theoretically you could report a tax loss with TIPS in times of severe deflation. The decrease in principal could be larger than your interest payment. You would still receive cash from your interest coupon. If your principal were to remain below par (i.e., the original purchase amount) until it reached maturity, it would be stepped up to equal par at maturity.

TIPS are exempt from state and local taxes. This is the same as with other Treasuries.

If you buy TIPS on the secondary market, the tax treatment is the same as with other bonds purchased on the secondary market: it can get complicated. You have to include an adjustment each year related to any premium or discount when you made your purchase.

Scott Burns favors keeping TIPS inside of an IRA because taxes are due immediately. In addition, there are no tax-related reasons for keeping them outside of an IRA. They do not produce taxed favored income. They produce regular taxable income.

[If you were a bond trader, you might have capital gains. However, very few individuals are able to profit from bond trading because of costs, especially when the amount traded is in an increment of less than $1.0 million. You can have gains, but seldom as a matter of routine.]

With I Bonds, you have your choice. You may defer taxes until you cash them in or you may choose to pay taxes each year on the interest and increases in principal.

I Bonds are exempt from state and local taxes.

I Bonds have a purchase limit. If I understand correctly, it is $60000 per social security number per year. To purchase this much, $30000 must be in the form of paper bonds (as through a bank) and $30000 must be in electronic form through Treasury Direct. A husband and wife could buy $120000 each year.

My understanding is that the interest rates on TIPS and I Bonds are reported differently. With TIPS, you are told the amount of the coupon. With I Bonds, the first inflation adjustment is included with your first interest payment. The current fixed portion of I Bonds interest is 1.20%. The current total interest is 4.80%.

It is likely that you will be able to put your lump sum into one IRA or into several IRAs. There can be reasons for owning several. Be knowledgeable of the section 72t rules related to Substantially Equal Periodic Payments from IRAs. Such payments can be structured around a single IRA while excluding other IRAs.

The real reason that I generally "ignore the tax treatment" is that including taxes is hard. A secondary reason is that it is hard to do right.

My calculators allow you to withdraw (i.e., not to reinvest) a fraction of interest and dividends. In fact, the portions can differ, corresponding to different tax rates.

I could point to some irrelevant excuses (such as everybody's tax situation is different). I prefer to be forthright and up front: it is hard to include taxes and even harder to do it right.

I am not offering fee-based assistance. However, I would be delighted to provide such assistance as I can on this board. I am sure that others would be interested to learn from your situation.

Be sure to specify anything that you do not want me to post.

Here are some links that I think will be helpful.

Treasury Direct
Treasury Direct Products
Treasury Direct I Bonds at a Glance
Treasury Direct TIPS

Here is a link to my earlier correspondence with Rob Bennett about the SAFE AND HAZARDOUS REGIONS of withdrawal rates.
May 30, 2005 Letters

Have fun.

John Walter Russell
I wrote this on June 5, 2005.Updated: April 5, 2007.