Things I still don't understand about TIPS

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beardsworth
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Things I still don't understand about TIPS

Post by beardsworth » Fri Aug 31, 2007 8:00 am

A bunch of questions here, but I thought it best to group them all in one place rather than clutter up the forum with a separate new post for each.

1. A holder of TIPS in a taxable account must pay "as you go" federal income tax on the bonds' "phantom" interest, i.e., the inflation adjustment which has accrued to the bond but which the bondholder won't actually receive in cash form until the bond matures. It seems to me that if we entered a period of hyperinflation, it's possible that a holder of TIPS in a taxable account could really get squeezed, scrambling for money from other sources to pay tax on large amounts of phantom TIPS earnings s/he hasn't actually received. Or am I missing something here? (I'm thinking of Larry Swedroe's rule not to treat the unlikely as impossible--and wondering about the implications of taxable TIPS during extraordinary inflation.)

2. If I understand correctly, Series I Savings Bonds never lose their previously accrued earnings, even if deflation sets in. (You buy a $1000 I Bond, inflation increases it to $1250, and then deflation occurs. Your I Bond will stop increasing, but its value will not fall below the $1250 already achieved.) TIPS, I think, are subject to both upward/downward adjustments in value for inflation/deflation, although the holder will always get back at least the bond's original face value at maturity. Question: if TIPS are held in taxable account, and the owner has already paid income tax on phantom earnings from inflation, but then deflation occurs and the bond's value is adjusted downward, what happens to the income taxes already paid on inflation earnings that have now disappeared from the bond's value? Does the government get to keep those previous tax payments anyway (a good deal for the government), or is there some kind of eventual tax refund/adjustment based on the TIPS' actual earnings (up and down) across its entire lifetime through maturity?

3. Do I understand correctly that if TIPS are held in a pre-tax (non-Roth) retirement account, the account holder loses the exemption from state taxes which would otherwise apply to Treasury issues? If so, why is that? (I think it's because tax authorities can't, or don't, distinguished between Treasury and non-Treasury distributions from a pre-tax account.) Would the answer be the same if TIPS were the ONLY holdings in that pre-tax account, so that there was no doubt that all account distributions came from Treasury securities?

4. Is a Roth IRA actually the best place, if possible, to hold TIPS--because it eliminates all issues about state tax exemptions and about federal taxation of "phantom" TIPS earnings?

5. Some TIPS auctions are listed as "reopenings." What does that mean? Is it simply a second chance to buy more of that particular TIPS at the same interest rate as was already set at its original auction? Or can a "reopening" set an entirely different interest rate of its own?

As I said, lots of stuff here. Feel free to respond to whatever interests you, and I'll hope to piece together a complete picture from various replies.

Thanks.

Marc

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mas
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Re: Things I still don't understand about TIPS

Post by mas » Fri Aug 31, 2007 8:19 am

MarcMyWord wrote:1. A holder of TIPS in a taxable account must pay "as you go" federal income tax on the bonds' "phantom" interest, i.e., the inflation adjustment which has accrued to the bond but which the bondholder won't actually receive in cash form until the bond matures. It seems to me that if we entered a period of hyperinflation, it's possible that a holder of TIPS in a taxable account could really get squeezed, scrambling for money from other sources to pay tax on large amounts of phantom TIPS earnings s/he hasn't actually received. Or am I missing something here? (I'm thinking of Larry Swedroe's rule not to treat the unlikely as impossible--and wondering about the implications of taxable TIPS during extraordinary inflation.)
Would you rather pay tax on gains, or not have gains. In hyperinflation, TIPS will outperform nominal bonds even after taxes. Yes you may have to sell some of your TIPS to pay the tax.

MarcMyWord wrote:3. Do I understand correctly that if TIPS are held in a pre-tax (non-Roth) retirement account, the account holder loses the exemption from state taxes which would otherwise apply to Treasury issues? If so, why is that? (I think it's because tax authorities can't, or don't, distinguished between Treasury and non-Treasury distributions from a pre-tax account.) Would the answer be the same if TIPS were the ONLY holdings in that pre-tax account, so that there was no doubt that all account distributions came from Treasury securities?
You are correct. Even if your account is 100% Treasury, the distributions are subject to state tax. Why? Thats just the way it is :?
MarcMyWord wrote:4. Is a Roth IRA actually the best place, if possible, to hold TIPS--because it eliminates all issues about state tax exemptions and about federal taxation of "phantom" TIPS earnings?
In a ROTH you paid taxes upfront (even state taxes), in a traditional IRA you pay them on withdrawal. I do not see any difference here (but I haven't done the math). The "phantom" income problem is only relevant to a taxable account - both ROTH and TIRA defer this until a withdrawal is made.
MarcMyWord wrote:5. Some TIPS auctions are listed as "reopenings." What does that mean? Is it simply a second chance to buy more of that particular TIPS at the same interest rate as was already set at its original auction? Or can a "reopening" set an entirely different interest rate of its own?
The bonds will have the same coupon, the same maturity date (i.e. maybe 9.5 yrs left to maturity instead of 10). The "rate" (yield to maturity) you will receive may differ because the auction will determine a new price. The face value will also differ due to accrued inflation.

SteveB3005
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Post by SteveB3005 » Fri Aug 31, 2007 8:24 am

MarcMyWord
Feel free to respond to whatever interests you

"Mark my words" and "I'll tell you one thing" were my moms favorite sayings when I was growing up. I always found myself putting this little mental check mark on her sentences, still do. Also learned a valuable lesson that when people say, "I'll tell you one thing" you can really count on them saying a lot of other things right behind it.

On your question number 3, you have it right. It will be taxed as ordinary income at the time of distribution without state exemption on those treasuries.

zigkelton
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Post by zigkelton » Fri Aug 31, 2007 8:52 am

Relative to Q1:
TIPS bonds held directly are federally taxed on both the current real rate and the current amount of fathom (non-cash) inflation adjustment.

However, while it was not mentioned yet, I believe :?: TIPS bought through the Vanguard fund (VIPSX or VAIPX) work differently. If I am correct, the fund pays both the real rate and inflation adjustment on a quarterly, cash basis.

Could someone please confirm or correct my understanding, so I don't propagate any mis-information? Thanks :)
Last edited by zigkelton on Fri Aug 31, 2007 9:08 am, edited 1 time in total.

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mas
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Post by mas » Fri Aug 31, 2007 8:59 am

zigkelton wrote:TIPS bought through the Vanguard fund (VIPSX or VAIPX) work differently. If I am correct, the fund pays both the real rate and inflation adjustment on a quarterly, cash basis.
That is correct.

Topic Author
beardsworth
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Post by beardsworth » Fri Aug 31, 2007 9:13 am

Oops. I realize that Vanguard's fund distributes everything. But in my own case, in making the original post, I was just referring to direct purchase of individual TIPS at auction, either through a taxable Treasury Direct account, or through a brokerage Roth or pre-tax IRA.

Marc

deci02
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Post by deci02 » Fri Aug 31, 2007 9:56 am

2. If I understand correctly, Series I Savings Bonds never lose their previously accrued earnings, even if deflation sets in. (You buy a $1000 I Bond, inflation increases it to $1250, and then deflation occurs. Your I Bond will stop increasing, but its value will not fall below the $1250 already achieved.) TIPS, I think, are subject to both upward/downward adjustments in value for inflation/deflation, although the holder will always get back at least the bond's original face value at maturity. Question: if TIPS are held in taxable account, and the owner has already paid income tax on phantom earnings from inflation, but then deflation occurs and the bond's value is adjusted downward, what happens to the income taxes already paid on inflation earnings that have now disappeared from the bond's value? Does the government get to keep those previous tax payments anyway (a good deal for the government), or is there some kind of eventual tax refund/adjustment based on the TIPS' actual earnings (up and down) across its entire lifetime through maturity?
IRS allows a negative OID adjustment for deflation. You can subtract the loss from prior gains to the security.
5. Some TIPS auctions are listed as "reopenings." What does that mean? Is it simply a second chance to buy more of that particular TIPS at the same interest rate as was already set at its original auction? Or can a "reopening" set an entirely different interest rate of its own?
Yes, a second chance at the same security with the same maturity date. Original coupon rate will be the same but actual yield can be different and is set at auction.

Regards,
Doug

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Doc
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Post by Doc » Fri Aug 31, 2007 10:06 am

MarcMyWord wrote:
1. It seems to me that if we entered a period of hyperinflation, it's possible that a holder of TIPS in a taxable account could really get squeezed, scrambling for money from other sources to pay tax on large amounts of phantom TIPS earnings s/he hasn't actually received.
True but highly irrelevant. If there was hyperinflation and if all you held was a single Inflation Protected Bond it might be of concern but these two things occurring at the same time are very unlikely. People usually hold a number of TIPS with varying maturities and can use part of the maturing bonds to pay any taxes due on the others. Furthermore a TIPS fund pays out the “phantom income’ as dividends so you don’t have any cash flow problems if you own the fund.
3. Do I understand correctly that if TIPS are held in a pre-tax (non-Roth) retirement account, the account holder loses the exemption from state taxes which would otherwise apply to Treasury issues?

Yes and no. It turns out that the after tax future value for both a Traditional IRA (TIRA) and a ROTH are exactly the same except for the (possible) difference in tax rates now and at withdrawal. So you “lose” the state tax exemption but you don’t pay any taxes on your portion of the account regardless if it a TIRA or a ROTH. (Assuming that your state doesn’t tax IRAs.)

Mas, The distributions may be subject to state and federal taxes but it turns out that your portion of the gains are not. (The tax that you pay is actually only the future value of the tax that was "deferred" when you made the original contribution. The "interest" rate charged is variable and equals the return of your total investments. You have to really study the math to figure this out because the IRS rules don't give you any clue.)
4. Is a Roth IRA actually the best place, if possible, to hold TIPS--because it eliminates all issues about state tax exemptions and about federal taxation of "phantom" TIPS earnings?
This is not relevant. If your tax rate is higher now then when you withdrawal the funds it might be better not to anything into a ROTH. You have to pay extra taxes. The extra taxes put you in a “hole” from the get-go.

Mas, I have done the math and there is no difference.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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