Do I-bonds (vs TIPS) make any long term sense in taxable space?

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kiddoc
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Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by kiddoc » Sun Sep 10, 2017 12:18 pm

Edit- I made an error in I-bond calculations as pointed out by #cruncher below. Removing my I-bond calculations for now. Please refer to #cruncher's post below.

Let's assume the decision to invest in inflation protected bonds makes sense from a financial situation standpoint and there is no space for these in tax-protected avenues. We are trying to aim for principal and inflation protection (not the highest yielding investment or education). Buying individual bonds and holding to maturity to avoid interest rate sensitivity.

Assumptions:
Marginal federal tax rate now: 30%
Expected marginal federal tax rate in retirement: 20%
Ibond fixed rate: 0%
30 year TIPS coupon: 0.9%
One time allocation: $10,000


Scenario 1: Avg inflation: 2%. TIPS yield adjusted for 30% taxes: (2.9*0.7= 2.03%)
I-bond numbers were erroneous
TIPS pays taxes along the way and value at 30 years= 18274.13

Scenario 2: Avg inflation: 4%. TIPS yield adjusted for 30% taxes: (4.9*0.7= 3.43%)
I-bond numbers were erroneous
TIPS pays taxes along the way and value at 30 years= 27503.99

Scenario 3: Avg inflation: 5%. TIPS yield adjusted for 30% taxes: (5.9*0.7= 4.13%)
I-bond numbers were erroneous
TIPS pays taxes along the way and value at 30 years= 33672.55

Of course, I am an amateur may have made simple math errors. Please feel free to correct them. However, based on this calculation, I-bonds only make sense if the average inflation over the life of the bond approaches 5% or more. Of course, fixed rate rise may change the calculation but I suspect that will be accompanied by an increase in TIPS coupons as well. I also ran the numbers using a 15% tax rate in retirement and then the inflation break-even point is 4%.

I am leaning towards buying individual TIPS every year. I suspect using TIPS bond funds would complicate matters as they have a rolling maturity date and outcomes might be harder to predict.
Last edited by kiddoc on Sun Sep 10, 2017 1:39 pm, edited 1 time in total.
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Jack FFR1846
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by Jack FFR1846 » Sun Sep 10, 2017 1:04 pm

iBonds work very well in an emergency fund after they're a year old. When cashed, they don't trigger state or local taxes and if your income works and you titled them correctly when buying, they can be used federal tax free for college costs.

I've never considered tips so can't comment on comparisons.
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kiddoc
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by kiddoc » Sun Sep 10, 2017 1:17 pm

Jack FFR1846 wrote:
Sun Sep 10, 2017 1:04 pm
iBonds work very well in an emergency fund after they're a year old. When cashed, they don't trigger state or local taxes and if your income works and you titled them correctly when buying, they can be used federal tax free for college costs.

I've never considered tips so can't comment on comparisons.
I agree. I also think they are good vehicles for emergency funds or short term funds. I was wondering more about the choice for inflation protected bonds (I-bonds vs TIPS) in a retirement portfolio.
"The four most dangerous words in investing are: 'this time it's different.'" - Sir John Templeton


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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by #Cruncher » Sun Sep 10, 2017 1:26 pm

kiddoc wrote:
Sun Sep 10, 2017 12:18 pm
Scenario 1: ... After 30 years, the Ibond is worth 18113.62 and taxes @ 20%= 3622.72. After tax value =14490.89
When an I Bond matures one pays tax only on the gain, not on the total value. Therefore, given your assumptions, kiddoc, the breakeven inflation rate is 3.8616% as shown in the middle column below. If the I Bond tax rate was 30% like the TIPS rate, it would be 5.3754% as shown in the far right column.

Code: Select all

Principal                              10,000
Years                                      30
TIPS yield                            0.9000%
I Bond fixed rate                     0.0000%
TIPS tax rate                             30%
I Bond tax rate                           20%       20%       30%
Annual CPI increase                   2.0000%   3.8616%   5.3754%
TIPS after tax yield                  2.0426%   3.3575%   4.4266%
TIPS value in 30 years                 18,342    26,931    36,672
I Bond pretax value in 30 years        18,114    31,164    48,103
I Bond tax                              1,623     4,233    11,431
I Bond after tax value in 30 years     16,491    26,931    36,672
I Bond versus TIPS                     (1,851)        0         0
I also calculated the TIPS after tax yield a little differently than you did. For example with 2% inflation, instead of 2.03% I get
2.0426% = 70% * (1.009 * 1.02 - 1)

Be aware that 0% fixed rate I Bonds will likely do a little better than shown because of the 0% floor on each six-month composite rate. (See my post, Re: Don't really understand TIPS duration..., for more.) Also be aware that tax reporting on individual TIPS held in a taxable account can be complicated. A TIPS fund would be much simpler.

whomever
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by whomever » Sun Sep 10, 2017 1:28 pm

Depending on what you want your total allocation to be, if inflation is high enough interest rates will presumably rise. If you trade in low yield IBonds somewhere along the way to get new, higher, interest rates you don't take a hit on the principal value.

Even if you plan to increase your inflation protected space by $10k a year, if for example inflation is galloping along in 5 years you could always sell the older low yield IBonds and buy new higher yield TIPS while still buying $10k of new IBonds every year.

kiddoc
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by kiddoc » Sun Sep 10, 2017 1:32 pm

#Cruncher wrote: When an I Bond matures one pays tax only on the gain, not on the total value.
:oops: I thought I was making some major error somewhere as I had read something between 3-4% as the break even point in the past. Thanks.
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by JBTX » Sun Sep 10, 2017 1:52 pm

Ibonds make sense in a taxable space to park cash for periods 1-5 years, and also emergency funds after a year. Basically ibonds will grow with inflation. They will have no real yield. But taxes are deferred until withdrawn

TIPS typically are not best for taxable space. You will get taxed for imputed interest every year. You would have to hold for more than 5 years for the TIPS to beat the ibonds and that is ignoring the TIPS unfavorable tax treatment

https://tipswatch.com

I own ibonds in my taxable accounts. Roughly half of my cash reserve. I own TIPS in my tax deferred retirement Accounts.

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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by grabiner » Sun Sep 10, 2017 2:44 pm

For long-term savings, the higher yield on TIPS may outweigh the tax deferral on I Bonds, but only if you know the term. If you buy a 30-year TIPS and need the money in 20 years, you risk losing some of your principal because of rising rates. An I Bond can be cashed in at any time after five years and will earn its guaranteed return.

Another important issue is your tax rate over time. If you are buying I Bonds for retirement savings, you might be able to pay all the taxes when you are in a lower tax bracket; with a TIPS, you will pay tax every year in a higher bracket.

Thus, if you know that you won't need the money for X years, and you will be in about the same tax bracket after those X years, and X is large, then a TIPS maturing in X years may be a better investment than an I Bond. Since this is not a common situation, it is normally recommended that you max out I Bonds before buying any TIPS in a taxable account.

But TIPS are OK in a taxable account if you need to hold them there. If your bond was worth $10,000 par value last year, and is worth $10,300 including dividends this year, you will owe tax on $300 whether it is a conventional bond or a TIPS. The issue with TIPS is that you might receive $100 in interest and also owe tax on the inflation adjustment; therefore, you have to manage the cash flow or sell some bonds to cover the tax. (Another solution to the cash-flow issue is to hold TIPS ETFs, which distribute the inflation adjustment every year; LTPZ is a long-term TIPS ETF at a low cost.)
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Re: Do I-bonds (vs TIPS) make any long term sense in taxable space?

Post by Mel Lindauer » Sun Sep 10, 2017 3:55 pm

In addition to the tax-shifting from a current higher tax bracket to a lower one in retirement that's already been pointed out, I Bonds can also be used, tax-free, for qualifying educational expenses for you and/or any dependents. And, even if the kids have already finished college, some investors may have plans to return to college in retirement, and I Bonds can come into play in that situation, too.
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