Rethinking I-bonds vs Tax Advantaged TIPS fund

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Buffetologist
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Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by Buffetologist » Mon Nov 13, 2017 9:52 am

I have been buying the maximum I-bonds since 2011 in TreasuryDirect. I am in the 39.6% bracket now and expect to be in the 28% in retirement based on current tax rates.

I also have access to and have been using the Fidelity Inflation Protected Index Fund (FSIYX) in my 401K. I have my new money put into a bond fund and when the 5-yr real yield on TIPS is about 0.25% or more, I convert some to FSIYX. This way I think I am ensuring that my purchases are done with a positive real yield.

I've been trying to allocate about 10% of my portfolio to inflation-protected securities. It's occurred to me that the TIPS in the mutual fund inside the 401K is a much better place to hedge inflation than taxable I-bonds because the ultimate income tax due on the I-bonds guarantee that I under-perform inflation by a significant margin.

Does this kind of thinking make sense? I am thinking of

1) liquidating the I-bonds in my taxable and just paying the darn tax
2) buying a stock index fund with the proceeds
3) Selling stocks in my 401K and buying FSIYX so that my allocation is restored, while ensuring I don't end up with a wash sale.

Continuing to hold the I-bonds continues to ensure that these securities continue to lag inflation.

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Mel Lindauer
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Re: Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by Mel Lindauer » Mon Nov 13, 2017 5:28 pm

Buffetologist wrote:
Mon Nov 13, 2017 9:52 am
I have been buying the maximum I-bonds since 2011 in TreasuryDirect. I am in the 39.6% bracket now and expect to be in the 28% in retirement based on current tax rates.

I also have access to and have been using the Fidelity Inflation Protected Index Fund (FSIYX) in my 401K. I have my new money put into a bond fund and when the 5-yr real yield on TIPS is about 0.25% or more, I convert some to FSIYX. This way I think I am ensuring that my purchases are done with a positive real yield.

I've been trying to allocate about 10% of my portfolio to inflation-protected securities. It's occurred to me that the TIPS in the mutual fund inside the 401K is a much better place to hedge inflation than taxable I-bonds because the ultimate income tax due on the I-bonds guarantee that I under-perform inflation by a significant margin.

Does this kind of thinking make sense? I am thinking of

1) liquidating the I-bonds in my taxable and just paying the darn tax
2) buying a stock index fund with the proceeds
3) Selling stocks in my 401K and buying FSIYX so that my allocation is restored, while ensuring I don't end up with a wash sale.

Continuing to hold the I-bonds continues to ensure that these securities continue to lag inflation.
Something to keep in mind is that you'll have to pay state (and perhaps local) taxes on your 401K withdrawals, so if you live in a state where you have one or both, that could well negate any advantage to holding TIPS in your tax-deferred account.

And you're willing to pay taxes at your high rate to redeem the I Bonds now, rather than later when you're in a lower tax bracket?

Hopefully, you have (or will) consider both of those things when marking your decision.
Best Regards - Mel | | Semper Fi

aristotelian
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Re: Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by aristotelian » Mon Nov 13, 2017 5:43 pm

What if you cash in the I Bonds with a 0% effective rate? There have been threads here of people paying 0% effective tax with 100k of expenses in retirement.

I also don't see how TIPS in the 401k solves the problem since the gains will be taxed.

Buffetologist
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Re: Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by Buffetologist » Mon Nov 13, 2017 5:55 pm

Mel Lindauer wrote:
Mon Nov 13, 2017 5:28 pm
Buffetologist wrote:
Mon Nov 13, 2017 9:52 am
I have been buying the maximum I-bonds since 2011 in TreasuryDirect. I am in the 39.6% bracket now and expect to be in the 28% in retirement based on current tax rates.

I also have access to and have been using the Fidelity Inflation Protected Index Fund (FSIYX) in my 401K. I have my new money put into a bond fund and when the 5-yr real yield on TIPS is about 0.25% or more, I convert some to FSIYX. This way I think I am ensuring that my purchases are done with a positive real yield.

I've been trying to allocate about 10% of my portfolio to inflation-protected securities. It's occurred to me that the TIPS in the mutual fund inside the 401K is a much better place to hedge inflation than taxable I-bonds because the ultimate income tax due on the I-bonds guarantee that I under-perform inflation by a significant margin.

Does this kind of thinking make sense? I am thinking of

1) liquidating the I-bonds in my taxable and just paying the darn tax
2) buying a stock index fund with the proceeds
3) Selling stocks in my 401K and buying FSIYX so that my allocation is restored, while ensuring I don't end up with a wash sale.

Continuing to hold the I-bonds continues to ensure that these securities continue to lag inflation.
Something to keep in mind is that you'll have to pay state (and perhaps local) taxes on your 401K withdrawals, so if you live in a state where you have one or both, that could well negate any advantage to holding TIPS in your tax-deferred account.

And you're willing to pay taxes at your high rate to redeem the I Bonds now, rather than later when you're in a lower tax bracket?

Hopefully, you have (or will) consider both of those things when marking your decision.
Thanks for the reply. When I do my asset allocation, I assume a certain tax rate in retirement. Say 31% state and federal.

To compare taxable and non-taxable in the same asset allocation, I multiply the principal in ALL of my 401K by 0.69 before comparing to the taxable stuff. There is nothing I can do to avoid this, the taxes eventually have to be paid by me or my heirs on the whole balance. However, if there is a 2% interest rate, I get the whole 2% since I've already discounted the entire balance. In tax-advantaged space, the taxes discount the principal not the rate. That's why I try to put the bonds in tax advantaged.

In taxable, the taxes discount the final value and thus lower the effective rate. If I am getting 2% but am paying 45% in taxes, I'm really only getting 1.1%

That's why if the TIPS have a positive real yield, then I get that yield, but for the I-bonds, the yield is discounted by the tax I eventually have to pay making it impossible to keep up with inflation.

I think that I am thinking about this correctly, but wanted to discuss my reasoning for confirmation.

aristotelian
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Re: Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by aristotelian » Mon Nov 13, 2017 6:16 pm

I am not following. First of all, why is the premise important? In other words, why is it necessary that I Bonds match inflation after tax? Either way, they are giving you a variable rate that adjusts with inflation.

Regarding the math, I believe your fallacy is that you could put anything in your 401k. You have already gotten that tax deduction. The only reason TIPS are coming out ahead is because they are getting the advantage of the 401k.

Let's say you buy $10k of I Bonds vs converting $10k of your 401k to TIPS and they grow to $13K in 10 years. If you redeem the I Bonds you owe taxes on the $3k (although they are exempt from state and local). If you go with TIPS, you owe federal and state taxes on the whole $13k. It is true that you may owe less than your current marginal rate, but that is only because of the benefits of the 401k rather than any quality of TIPS.

Also consider that the taxes paid on I Bond interest is the price of opening space in your 401k for stocks and bonds with a positive expected real return. I would guess that long term you will come out way ahead overall if you do not take up space in your 401k with TIPS.
Last edited by aristotelian on Mon Nov 13, 2017 6:57 pm, edited 1 time in total.

grok87
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Re: Rethinking I-bonds vs Tax Advantaged TIPS fund

Post by grok87 » Mon Nov 13, 2017 6:23 pm

I think you have a valid point.

But ibonds, as mel, pointed out have certain state tax advantages compared to tips in a regular ira/401k.

Another one is better deflation protection. Ibonds can only go up.

Another one is real interest rate protection. If real rates rise then tips will take a hit whereas i bonds will not.

It's hard to value those other features.
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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