OID and TIPS: Calling all tax mavens

[McQ]

You are a maven in my book if you understood the reference to Original Issue Discount, and knew that the inflation adjustment to TIPS shows up on each year’s 1099 as OID, adding to ordinary income, and incrementing the tax due accordingly—even though those inflation adjustments won’t be received in hand until the bond matures. Aka, phantom income.

My question is whether I correctly understand how the nth year OID is calculated. Here is how I did it initially (and please be blunt if I did it wrong).

1. Assume a 20-year TIPS ladder under idealized and simplified conditions:
a. All bonds bought at par and all bonds have a 2% coupon.
b. One coupon payment at the end of the year & all bonds mature exactly at the end of the year, so that the full year’s inflation adjustment applies to each
c. Inflation 3% throughout.
d. One million dollars put into the ladder
e. Tax bracket is 24%

2. If this TIPS ladder was in a Roth account, each year’s withdrawal would be $61,157 real. There would be no OID, no tax on the coupon, and it wouldn’t matter that some of each year’s withdrawal represents basis. The nominal withdrawal amount will inflate up each year by 3% compounded, but all of it will always be tax free.

3. Now switch to an ordinary taxable brokerage account
a. The coupon will be $20,000 real, so that $41,157 of basis must be withdrawn that first year to get the $61,157 payout
b. The nominal payout (which is what the IRS taxes) will be:

i. $20,600 inflated coupon, plus
ii. $42,391 of inflated principal.

c. OID that first year will be $30,000, since the entire $1 million was subject to the full year’s inflation. Of that, $1,235 will have been paid out as the inflation adjustment to the maturing principal.
d. Taxable income is the inflated coupon plus all the OID, $50,600.

So far, so good (I hope). It’s the next phase where I grow uncertain. The spreadsheet picture below may help. Here in text I’ll just discuss the second year.



Year two
4. As shown, as the ladder liquidates over time, the real coupon goes down and down and the share of the total payment from maturing principal (real basis) goes up and up.

5. Coupons are taxed, OID is taxed, but return of basis is not taxed. The hit from phantom income grows less over time, and real after-tax income increases.

6. Now to the OID question. On my first take I calculated the 2nd year OID as $29,628. I reasoned as follows:
a. At the end of Year One, the inflated value of the million dollar purchase was $1,030,000, giving the Year One OID of $30,000
b. At the beginning of Year Two, there is $1,030,000 nominal, minus the nominal $42,391 distributed at the end of Year One, or $987,609 nominal in the account (yellow column)
c. OID, after another year of inflation, should thus be $29,628, or 3% of that amount.

But is that correct? Or am I missing some adjustment that would either reduce or expand the OID as the years proceed?

After the first pass, it occurred to me that I was computing OID on an inflation-compounded basis. An alternative would be to compute each year’s OID on the remaining (real) basis. Thus, (green column) the real basis after one year is $958,843 ($41,157 of basis having been withdrawn in the first year). If OID is 3% of that amount, the 2nd year OID drops from $29,628 to $28,765.

In plain English, the hit from phantom income is less under the second approach to calculating OID on TIPS. Over the 20 years, real after-tax income distributed will be about $14,000 greater.

So, which OID calculation is correct, inflation multiplied by the inflation compounded remaining account value, or inflation times the remaining basis? Anybody know?

Why it matters

Note how OID reduces the after-tax real payout in the initial years. That’s why people say a taxable account is the wrong location for a TIPS ladder.

But I can’t calibrate how wrong unless I’ve got the OID calculations correct.

[ofckrupke]

OID for each acquisition lot is computed as the difference in index ratios at beginning and end of the holding period (here, the full year) times the face value held. The index ratio is a compounding quantity. Your first way is equivalent, so long as your initial OID basis is the sum of inflated face values of the start-date holdings and all dispositions are at par.

To see that the second way is no good, consider the case with no drawdown, a single 20y TIPS (bought at par) and the (convenient to my purpose) combo of zero coupon & constant annual inflation rate = 20th root of two, minus 1....about 3.5265%...throughout the term. So 1 million nominal inflates to 2 million. But using your 2nd method the sum of OID reported over the 20y would be $705.3k, not 1M as required for the cumulative appreciation to have been fully reported and taxed via the OID mechanism.

[McQ]

OID for each acquisition lot is computed as the difference in index ratios at beginning and end of the holding period (here, the full year) times the face value held. The index ratio is a compounding quantity. Your first way is equivalent, at least under your simplifying condition that all rungs are acquired at par.

To see that the second way is no good, consider the case with no drawdown, a single 20y TIPS (bought at par) and the (convenient to my purpose) combo of zero coupon & constant annual inflation rate = 20th root of two, minus 1....about 3.5265%...throughout the term. So 1 million nominal inflates to 2 million. But using your 2nd method the sum of OID reported over the 20y would be $705.3k, not 1M as required for the cumulative appreciation to have been fully reported and taxed via the OID mechanism.

Very helpful, thanks! The argument that 100% of the total inflation adjustments must show up in OID was powerful. That's how I'd write the regulations if I was the Treasury/IRS.

[FactualFran]

When there are no transactions during a year, the OID for a year is the difference between the inflation-adjusted principal for successive years.

This non-mavin would do the calculations in terms of dollars as of each year and then adjust the after-tax amount for inflation since the initial year to calculate the real after-tax amount (in terms of dollars as of the initial year).

The real after-tax dollar amount would vary little over the years by using a different initial principal for each maturity year. In this case, by having an initial principal that is $400 more for each successive maturity year: $50,400 for the second year, $50,800 for the third year, and so on.

Later added

Here is a table of results for each rung having an initial principal of $50,000.

Code: Select all

     Purchase    Start      End    Maturing    OID   Coupon  Maturing  Post-Tax     Real
Year  Princp.   Princp.   Princp.   Princp.  Amount  Amount  +Coupon  Matur+Coup  Post-Tax
1     50,000  1,000,000  1,030,000   51,500  30,000  20,600   72,100    59,956     58,210
2     50,000    978,500  1,007,855   53,045  29,355  20,157   73,202    61,319     57,799
3     50,000    954,810    983,454   54,636  28,644  19,669   74,305    62,710     57,389
4     50,000    928,818    956,682   56,275  27,865  19,134   75,409    64,130     56,978
5     50,000    900,407    927,419   57,964  27,012  18,548   76,512    65,578     56,568
6     50,000    869,456    895,539   59,703  26,084  17,911   77,613    67,055     56,157
7     50,000    835,837    860,912   61,494  25,075  17,218   78,712    68,562     55,747
8     50,000    799,418    823,401   63,339  23,983  16,468   79,807    70,098     55,336
9     50,000    760,062    782,864   65,239  22,802  15,657   80,896    71,666     54,926
10    50,000    717,625    739,154   67,196  21,529  14,783   81,979    73,264     54,515
11    50,000    671,958    692,117   69,212  20,159  13,842   83,054    74,894     54,105
12    50,000    622,905    641,592   71,288  18,687  12,832   84,120    76,555     53,694
13    50,000    570,304    587,413   73,427  17,109  11,748   85,175    78,249     53,284
14    50,000    513,987    529,406   75,629  15,420  10,588   86,218    79,976     52,873
15    50,000    453,777    467,390   77,898  13,613   9,348   87,246    81,736     52,463
16    50,000    389,492    401,177   80,235  11,685   8,024   88,259    83,529     52,052
17    50,000    320,941    330,570   82,642   9,628   6,611   89,254    85,356     51,642
18    50,000    247,927    255,365   85,122   7,438   5,107   90,229    87,218     51,231
19    50,000    170,243    175,351   87,675   5,107   3,507   91,182    89,115     50,821
20    50,000     87,675     90,306   90,306   2,630   1,806   92,112    91,047     50,410

The purchase principal is that of the rung maturing in the year corresponding to the row. For each year, the other values in each row are:

• starting principal is the ending principal for the previous year minus the maturing principal for the previous year, except for the first year for which it is the sum of the purchase principal of the rungs
• ending principal is the stating principal adjusted for the inflation rate, 3% per year in this case
• maturing principal is the purchase principal of the maturing rung adjusted for inflation since purchase
• OID amount is the ending principal minus the starting principal
• coupon amount is the ending principal multiplied by the interest rate, 2% per year in this case
• post-tax maturing+coupon is the sum of the maturing and coupon amounts minus the income tax, 24% in this case, on the OID and coupon
• real post-tax is the post-tax maturing+coupon adjusted for inflation

[McQ]

When there are no transactions during a year, the OID for a year is the difference between the inflation-adjusted principal for successive years.

This non-mavin would do the calculations in terms of dollars as of each year and then adjust the after-tax amount for inflation since the initial year to calculate the real after-tax amount (in terms of dollars as of the initial year).

The real after-tax dollar amount would vary little over the years by using a different initial principal for each maturity year. In this case, by having an initial principal that is $400 more for each successive maturity year: $50,400 for the second year, $50,800 for the third year, and so on.

Later added

Here is a table of results for each rung having an initial principal of $50,000.

Code: Select all

     Purchase    Start      End    Maturing    OID   Coupon  Maturing  Post-Tax     Real
Year  Princp.   Princp.   Princp.   Princp.  Amount  Amount  +Coupon  Matur+Coup  Post-Tax
1     50,000  1,000,000  1,030,000   51,500  30,000  20,600   72,100    59,956     58,210
2     50,000    978,500  1,007,855   53,045  29,355  20,157   73,202    61,319     57,799
3     50,000    954,810    983,454   54,636  28,644  19,669   74,305    62,710     57,389
4     50,000    928,818    956,682   56,275  27,865  19,134   75,409    64,130     56,978
5     50,000    900,407    927,419   57,964  27,012  18,548   76,512    65,578     56,568
6     50,000    869,456    895,539   59,703  26,084  17,911   77,613    67,055     56,157
7     50,000    835,837    860,912   61,494  25,075  17,218   78,712    68,562     55,747
8     50,000    799,418    823,401   63,339  23,983  16,468   79,807    70,098     55,336
9     50,000    760,062    782,864   65,239  22,802  15,657   80,896    71,666     54,926
10    50,000    717,625    739,154   67,196  21,529  14,783   81,979    73,264     54,515
11    50,000    671,958    692,117   69,212  20,159  13,842   83,054    74,894     54,105
12    50,000    622,905    641,592   71,288  18,687  12,832   84,120    76,555     53,694
13    50,000    570,304    587,413   73,427  17,109  11,748   85,175    78,249     53,284
14    50,000    513,987    529,406   75,629  15,420  10,588   86,218    79,976     52,873
15    50,000    453,777    467,390   77,898  13,613   9,348   87,246    81,736     52,463
16    50,000    389,492    401,177   80,235  11,685   8,024   88,259    83,529     52,052
17    50,000    320,941    330,570   82,642   9,628   6,611   89,254    85,356     51,642
18    50,000    247,927    255,365   85,122   7,438   5,107   90,229    87,218     51,231
19    50,000    170,243    175,351   87,675   5,107   3,507   91,182    89,115     50,821
20    50,000     87,675     90,306   90,306   2,630   1,806   92,112    91,047     50,410

The purchase principal is that of the rung maturing in the year corresponding to the row. For each year, the other values in each row are:

• starting principal is the ending principal for the previous year minus the maturing principal for the previous year, except for the first year for which it is the sum of the purchase principal of the rungs
• ending principal is the stating principal adjusted for the inflation rate, 3% per year in this case
• maturing principal is the purchase principal of the maturing rung adjusted for inflation since purchase
• OID amount is the ending principal minus the starting principal
• coupon amount is the ending principal multiplied by the interest rate, 2% per year in this case
• post-tax maturing+coupon is the sum of the maturing and coupon amounts minus the income tax, 24% in this case, on the OID and coupon
• real post-tax is the post-tax maturing+coupon adjusted for inflation

Thanks FactualFran. Your rule (subtract successive inflation adjusted amounts) seems consistent with the idea that 100% of all the inflation adjustments must show up in OID, same argument as Officer Krupke. Am I reading you correctly?

[AQ]

If no transaction in a calendar year, the tax liability is Interest Payment on 1099 INT, and OID on 1099 OID? I guess if there is a transaction, then we'll receive a 1099-B to reflect any gain/loss?

In an (unlikely) scenario, if there is a deflation adjustment, do we get a tax deduction for that year through a negative OID?

[FactualFran]

Thanks FactualFran. Your rule (subtract successive inflation adjusted amounts) seems consistent with the idea that 100% of all the inflation adjustments must show up in OID, same argument as Officer Krupke. Am I reading you correctly?

You are reading me correctly. With TIPS held in a taxable account, the sum of inflation adjustment amounts for a year should be on a Form 1099-OID issued for the account after the end of the year.

[FactualFran]

If no transaction in a calendar year, the tax liability is Interest Payment on 1099 INT, and OID on 1099 OID? I guess if there is a transaction, then we'll receive a 1099-B to reflect any gain/loss?

In an (unlikely) scenario, if there is a deflation adjustment, do we get a tax deduction for that year through a negative OID?

A Form 1099-INT issued for a year should include interest amount from TIPS for the year. A Form 1099-OID issued for a year should include the inflation adjustment amount from TIPS for the year. A Form 1099-B issued for a year should include the proceeds and, for a TIPS acquired during or after 2016, the basis.

A deflation adjustment should appear as a negative amount on a Form 1099-OID issued for the taxable account with TIPS. A deflation adjustment for a year first reduces the taxable income from the TIPS for the year. Any excess after that is an ordinary loss for the year up to the taxable income from the TIPS for previous years. Any excess after that is carried forward as a deflation adjustment to the next year.

Later added

For example, suppose only one TIPS is owned. For the

• first year of ownership, Form 1099-INT showed $100 of interest and Form 1099-OID showed $50 as the inflation adjustment
• second year of ownership, Form 1099-INT showed $200 of interest and Form 1099-OID showed -$700 as the inflation adjustment.

The income tax return for the second year should include a

• Schedule B that shows the $100 of interest and an OID adjustment that results in a net of $0 taxable interest due to the TIPS
• Schedule A that shows an ordinary loss of $150

A $350 deflation adjustment would be carried forward to the next year ($700 deflation adjustment for the year minus the $200 OID adjustment to the interest income for the year and minus the $150 ordinary loss for the year).