More TIPS

I wanted to write a bit more about TIPS (Treasury Inflation-Protected Securities) and a peculiar tax treatment quirk they have. As you recall, TIPS have an underlying rate and an inflation-adjusted rate added on top. Because they’re inflation-adjusted though, if you don’t hold them in tax-deferred accounts, you could be hit with a rather insidious tax issue.

You’re taxed on the income from your bond. If inflation is low, your apparent income, and thus taxes, are low. However, if inflation is higher, you will have an apparently larger income from the bond even though your real (after-inflation) rate of return is the same as before. For example, say you have a TIPS with a nominal rate of 4% and inflation is running 4%. You’re getting paid 8%. Say you’re taxed on that in the 25% bracket. You’re really getting 6% after taxes and your real return is 2% after inflation. Now let’s say inflation rockets to 12%. Now you’re getting paid 16% nominally (but still 4% real). Now you’re only getting 12% after taxes (75% of 16%). After inflation, you’re not making a dime. Nice, huh?

This is sometimes known as the ‘tax on the inflation tax.’ And it’s another reason why you should keep TIPS in tax-deferred accounts.