squirrel1963 wrote: ↑Thu Aug 04, 2022 11:06 pm
Kevin M wrote: ↑Thu Aug 04, 2022 8:34 pm
I don't like the term phantom income
, although I understand it's a common term, and I'm not going to change that. Unless one is cash flow constrained, I don't see the difference between reinvesting nominal dividends, which are taxed, and being taxed on the inflation adjusted principal of TIPS. One way to view it is as forced dividend reinvestment.
Regarding a fund which distributes the inflation adjusted principal, unless you reinvest it you are not getting the full benefit of the TIPS fund, at least the way I view it. So if you reinvest TIPS fund dividends, what's the difference? If you are cash flow constrained, and must receive the dividends to pay the taxes, then use a fund.
So far I am buying my individual TIPS in an IRA, but I am buying TIPS for family members in taxable, since they have little or no tax-advantaged space. I am not worried at all about the so called phantom income (and they don't even know what it is).
Bringing it back on topic, I don't see "phantom income" as a big deal with respect to the asymmetric risk being discussed.
My TIPS ladder is all in tax-deferred IRA, so I confess that I haven't spent much time to the thought of keeping TIPS in taxable, so perhaps I could be completely wrong, and if so, apologies. I fear that phantom income can be an issue in taxable even for a large nest egg under some circumstances and actually be victim of asymmetric risk.
During accumulation years you can pay taxes out of your pay, so presumably TIPS in taxable will not become an issue until retirement.
But consider a new retiree at 60 who has a nest egg of $3 M, who now wants to build a 30 year ladder paying 50K a year. Let's assume 0% TIPS just to keep things simple, let's ignore SSA benefits and let's pretend an emergency fund is not needed.
So this retiree builds a $50K * 30 = $1,500K TIPS ladder and puts $1.5M in VTI -- let's ignore the need for emergency funds in these calculations. If the TIPS ladder is in a pre-tax IRA the retiree will have $50K real dollars income a year, and because presumably tax bracket thresholds will be adjusted with inflation, (s)he will pay tax on such income at a very low bracket and use excess returns from stocks (if any) for discretionary expenses.
Now think of the taxable case and suppose this retiree did the ladder on 2022. Due to phantom income inflation adjustments there will be a taxable income on 9% of $1,500K = 135K in 2022, and because the retiree wanted to inflation protect the TIPS ladder the choice is now to pay taxes selling a portion of the stocks which has lost about 14.5% since the beginning of the year. So not only the retiree has a large tax bill at higher brackets, (s)he also needs to sell stocks during the worst possible time.
Now just imagine having sequence-of-return for 3 or more of these years, and all of a sudden you are exposed to sequence-of-returns asymmetric risk, having to pay a lot in taxes at higher tax brackets with funds that have lost a lot of value. This looks like a pretty bleak scenario to me and makes me think having TIPS in taxable may not be feasible for many folks who want a TIPS ladder for their LMP approach, while looking quite doable in tax-deferred space.
Again maybe I am wrong, so hopefully someone else will do a better math.
Unless you are incorrect, this is exactly why I believe that a TIPs ladder cannot work in taxable. In addition, the qualified dividends on the equity side are also now taxable (Using munis means no federal taxes for the bonds and also the equity dividends), and doing any Roth conversions is more expensive. And, you also need to count in the extra tax on selling the equities, because even though they are "down", they still have a low cost basis.
So, in your example, the extra taxable income on the portfolio (which, if using munis, currently has a taxable income of $75K of qualified dividends, so no fed tax due) is almost $167K ($135K from the TIPS inflation adjustment and $32K from the selling of $63K of VTI to cover the taxes), and extra taxes would be $63K on what was supposed to be a $100K withdrawal rate with no taxes.
Extra taxes would be (assuming 40% fed+state and 20% cap gains (fed+state) would be $52K (tips) + 5K (VTI dividends)+ 6K (LTCG on the selling of stock at 50% basis), or $63K. Plus, Roth conversions will be far more expensive.
So, 1/2 of the inflation adjustment is paid out, significantly narrowing the potential upside of TIPS over nominal munis. It also creates what feels like a very unpredictable and unstable portfolio, which could decimate the equity holdings at the exact time you do not want to be selling. And, it is not clear what you "get back" when inflation cools down.
And, yes, under these scenarios, nominals will take a beating due to rising interest rates, however, if your bond duration is appropriate, you will (should) come back ok, and as a retiree, you will actually get more and more income which can be put back into the portfolio, instead of taking out of the portfolio to pay taxes.
And, here is the kicker: Data over the past 75 years indicate that interest rates correlate highly with inflation, and are typically higher than inflation. If this continues to be true (maybe this time is different ?), then the differences between TIPS and nominals once the unexpected inflation becomes expected becomes very problematic for TIPS in taxable unless the real rate goes significantly higher than 0%.
https://www.spglobal.com/spdji/en/docum ... ersect.pdf
https://www.gzeromedia.com/the-graphic- ... rest-rates
So, TIPS look pretty good in tax sheltered while there is unexpected inflation. A lot of that goodness is tempered if they are in taxable. But what happens once the "unexpected" goes away and interest rates are the same or higher than inflation ?
Are TIPS a good hedge against inflation ? Or are they a good hedge against a prolonged increase in inflation ? There is a big difference between these two scenarios.
I am sure I have a number of things incorrect here, but I do not think this is simple and clear, especially in taxable.