Tax Planning for the Use of TIPS at Retirement

Executive Summary

• TIPS are Treasury bonds adjusted daily based on the consumer price index.
• The income from newly issued TIPS may be accounted for under either the coupon bond method or the discount bond method.
• TIPS may be purchased directly from Treasury or on the secondary market from a broker.

A retiree needs to have an income stream that is sufficient to meet living expenses for the rest of his or her life and that increases with inflation. The most common sources of inflation-protected income for retirees are Social Security and defined-benefit pension plans. Social Security benefits provide a lifetime income stream to beneficiaries that increases as the cost of living increases.¹ While the vast majority of retirees are eligible to receive Social Security payments, for most of them the payments are insufficient to meet day-to-day living expenses. For 2006, the estimated average monthly benefit was only $1,011 for all retired workers and $1,658 for a couple when both were receiving benefits.² These amounts are clearly not adequate to allow for a comfortable retirement for most retirees.

Defined-benefit pension plans normally will provide a lifetime income stream and may include a cost-of-living adjustment (COLA) provision. Almost all full-time local and state employees are offered a defined-benefit plan, the majority of which include at least a partial COLA. Currently, however, only about 21% of private-sector employees are offered a defined-benefit plan, and these plans usually do not have a COLA. Moreover, the trend is clearly away from defined-benefit plans in the private sector. In 1985, there were 112,000 private pension plans insured by the Pension Benefit Guaranty Corporation; in 2005 there were fewer than 30,000.³

Given the inadequacy of Social Security and the limited availability of defined benefit plans, particularly plans with a COLA, most retirees will need to have other investments that mimic these sources of retirement income. Investments that can provide lifetime income streams for retirees that increase over time with inflation include immediate annuities, equity-based dividends, and Treasury inflation-protected securities (TIPS). In addition to providing a potential lifetime rising income source, TIPS (as well as dividend-paying equities) give retirees the opportunity to pass on their assets to heirs. This article addresses how to efficiently use TIPS as a source of retirement income.⁴

Mechanics of TIPS

TIPS are Treasury bonds, the principal of which rises or falls in direct proportion to increases or decreases in the consumer price index for all urban consumers (CPI-U). Daily adjustments are made to the principal of the bonds using an index ratio based on changes in the CPI-U over that period. Specifically, the index ratio is computed by multiplying the reference CPI for the current date by the reference CPI on the date the bond was issued.

Example 1: TIPS, with a 10-year term and a stated interest rate of 3.375%, are issued on February 6, 1997. At the time of their issuance, the reference CPI is 158.43548 and on June 30, 2006, it is 201.44. On the latter date, the index ratio for these TIPS is 1.271 (201.44 ÷ 158.43548), and the adjusted principal for each $1,000 of original issuance is $1,271 ($1,000 × 1.271).

Interest on TIPS is paid semiannually based on the adjusted principal multiplied by half of the coupon or stated interest rate. TIPS are a unique asset because, as Treasury bonds, they are not subject to default risk and the income they generate represents a real rate of return, because the original principal preserves its original purchasing power due to the adjustments.

TIPS are currently offered with maturity lengths of 5, 10, or 20 years and are offered in denominations of $1,000. At maturity, the bondholder is paid the adjusted principal amount.⁵

Example 2: On April 15, J purchases five-year $1,000 TIPS with an annual stated interest rate of 2.375%. During the next six months, the CPI-U increases by 1.5%. Consequently, the $1,000 principal is adjusted upward by 1.5% to $1,015 ($1,000 × 101.5%) by the end of six months. At this time, J receives an interest payment of $12.05 ($1,015 × (2.375% ÷ 2)) to compensate him for six months of earned interest. During the next six months, the CPI-U increases by another 2%, so after one year it has increased by a total of 3.5%. The $1,000 principal is adjusted upward by 3.5% to $1,035 ($1,000 × 103.5%) during this period. J would receive another interest payment of $12.29 ($1,035 × (2.375% ÷ 2)) to cover the interest earned for the next six months. The interest payment in the second six-month period is slightly higher than in the first six-month period because of the higher adjusted principal. If J holds the TIPS until maturity, he will receive an adjusted principal that reflects the total increase in the CPI-U over the term of the bond.

As long as the retiree spends only the after-tax real return amount, he or she will preserve the purchasing power of the original investment. If the bond is purchased in the secondary market after the issuance date, the price paid for the bond will be higher (lower) than the adjusted principal if market interest rates have decreased (increased) since the bond was issued. The real return or yield of the bond will therefore be higher (lower) than the coupon or stated interest rate if the purchase price is lower (higher) than the adjusted principal. In this case, the amount that the retiree may withdraw without reducing the bond’s purchasing power is the real yield and not the stated rate (assuming the bond is purchased above or below the adjusted principal amount).

Obviously, the ability of the retiree to spend only the real return from the TIPS depends on both the retiree’s spending requirements and the real return of the retiree’s TIPS, which is set when the TIPS are purchased. TIPS were initially offered in 1997. Since that time the annual stated interest rates for 10- and 20-year TIPS have ranged from 1.625% to 4.25%.

Currently, longer-term TIPS are priced to yield an annual real return of 2.1–2.3% and regular Treasury bonds are priced to yield a nominal return of 4.5–4.7%, depending on their maturity date.⁶ The difference between the real return of TIPS and the nominal return of a regular Treasury bond with the same maturity represents the annual expected inflation rate over the remaining life of the TIPS. If, for example, TIPS are currently yielding 2.2% and a regular Treasury bond with the same maturity is yielding 4.7%, the annual expected inflation rate is 2.5%. If the inflation rate turns out to be greater than 2.5%, the holder is better off owning TIPS because the real yield plus the inflation adjustment to principal will exceed 4.7%. Conversely, if the annual inflation rate is less than 2.5%, the owner is better off holding regular Treasury bonds.

TIPS may be purchased outright or through mutual funds. If they are purchased outright, the retiree can avoid the ongoing expense charges imposed by the mutual funds. Also, because a TIPS mutual fund will normally not have a portfolio consisting exclusively of 20-year term TIPS, the retiree can only lock in a predetermined real rate for a longer period of time by purchasing the bonds outright. If the retiree does choose the mutual fund route, it is critical that he or she choose a fund with a low expense ratio because the expense charges directly reduce the real return to the retiree.⁷

Diversification Benefits

Even during retirement, it is important that the retiree maintain a balanced portfolio, which normally consists of a mix of stocks and bonds. The precise proportion will vary depending on the amount of risk (often defined by portfolio volatility) that a retiree is willing to assume in order to generate a higher expected rate of return. A portfolio that allocates a higher proportion to stocks would be expected to earn a higher rate of return but would be riskier.

The returns from TIPS are not strongly correlated with the returns from any asset class and are less volatile than conventional bonds. As a result, by substituting TIPS in a portfolio for a comparable amount of conventional bonds, the overall volatility of a portfolio should decrease. Alternatively, by replacing conventional bonds with TIPS, the retiree may be able to increase the proportion of the portfolio allocated to stocks without increasing its overall risk.⁸

Taxation of Newly Issued TIPS: Coupon and Discount Methods

For newly issued TIPS held in taxable accounts, there are two possible methods to account for the income from the TIPS: the coupon bond method and the discount bond method. Normally, a retiree will use the coupon bond method. This is used if two conditions are met: (1) the bond is issued at par and (2) all stated interest is qualified stated interest. The bond is considered to be issued at par if the difference between the issue price and principal amount is less than a de minimis amount (Regs. Sec. 1.1275-7(d)(2)(i)). Stated interest is qualified stated interest if the interest is unconditionally payable in cash or is constructively received under Sec. 451, at least annually at a single fixed rate (Regs. Sec. 1.1275-7(d)(2)(ii)).

The discount bond method is used if the bond is not eligible for the coupon method. For TIPS, it is used if the TIPS are traded as STRIPS (separate trading of registered interest and principal of securities) (Regs. Sec. 1.1286-2). While Treasury does not issue STRIPS directly to investors, they can be purchased through financial institutions and government securities brokers and dealers. Because STRIPS would normally not appeal to current retirees, only the coupon method will be discussed here.

Inflation Adjustment

Under the coupon bond method, the qualified stated interest payment is taken into account under the taxpayer’s regular method of accounting (Regs. Sec. 1.1275-7(d)(3)). Therefore, a cash basis taxpayer would recognize the income when it is received. In addition, any increase in the inflation-adjusted principal is treated as original issue discount (OID) and is taxable in the year the increase occurs, even if the taxpayer uses the cash-basis method (Regs. Sec. 1.1275-7(d)(4)).

Example 3: R purchases, at par, $100,000 in TIPS on April 15, 2006. The annual stated interest rate is 3%, to be paid semiannually. On October 15, when the index ratio is 1.02, the first interest payment of $1,530 ($102,000 × (3% ÷ 2)) is made. From April 15 through the end of the year, the index ratio is computed to be 1.03. The adjusted principal at the end of the year is $103,000. The amount classified as OID and subject to tax would be $3,000 ($103,000 – $100,000). The total amount of interest income taxable for the year would be $4,530 ($1,530 stated interest income + $3,000 OID income). R is taxed on both the coupon payment and the OID amount even though only the coupon payment is immediately paid to him.

Deflation Adjustment

In the rather unlikely event that the CPI-U actually experiences an overall decrease in a year and there is a deflation adjustment, the amount of qualified stated interest included in income during the year will be reduced by the amount of the deflation adjustment. If the deflation adjustment actually exceeds the stated interest income, the excess is treated as an ordinary loss for the tax year. However, the amount treated as an ordinary loss in the current year is limited to the amount by which the interest inclusions in the prior years exceed the total amount treated as an ordinary loss in prior tax years. If the deflation adjustment exceeds both the stated interest and the amount allowed to be deducted as an ordinary loss in the current year, the excess is carried forward to offset interest income (including principal increases) from the TIPS in subsequent years (Regs. Sec. 1.1275-7(f)(1)).

Example 4: Assume the same facts as in Example 3, except it is the end of the following year and the index ratio has declined from 1.03 to 1.025. R’s adjusted principal at the end of the year would be $102,500, and he would have a negative inflation adjustment of $500 ($103,000 adjusted principal at the end of the prior year – $102,500 at the end of the current year). This negative inflation adjustment would be used to reduce his current year’s stated interest income.

Purchase of TIPS on the Secondary Market

A retiree may purchase TIPS on the secondary market from a broker after the TIPS have been issued. If market rates have decreased since the bonds were issued, the TIPS will sell at an amount greater than the adjusted principal (a secondary market premium). Conversely, if market interest rates have increased since the bonds were issued, the TIPS will sell at less than the adjusted principal (secondary market discount).

Amortization of Secondary Market TIPS Premium

If bonds, including TIPS, are purchased in the secondary market at a premium, the bondholder may elect to amortize the premium over the bond’s remaining life and consequently reduce the amount of interest income recognized (Sec. 171(a)(1)). Generally, the election is advantageous because the holder trades off a postponed reduction in capital gain or an increase in capital loss if the premium is not amortized for an immediate reduction in interest income. A holder determines the bond premium on TIPS by assuming there is no further inflation or deflation, so the amount payable at maturity is equal to the adjusted principal on the date that the TIPS are acquired (Regs. Sec. 1.1275-7(f)(3)).The bond premium must be amortized using the constant-yield method; the straight-line method is not allowed (Regs. Sec. 1.171-2). The interest income to be reported would be the stated interest amount minus the amount of amortized premium.

Example 5: On April 15, 2007, T purchases 10-year term TIPS with an original issue price of $100,000 in the open market for $115,787. The bonds will mature on April 15, 2015, and are priced to yield 2.5%. The stated annual interest rate on the bonds is 3.5%. The adjusted principal of the TIPS on the purchase date is $108,000. On the purchase date, a stated semiannual interest payment of $1,890 ($108,000 × (3.5% ÷ 2)) is made. The amount of the bond premium is $7,787 ($115,787 – $108,000). Based on this information, a premium amortization schedule would be made to determine the semiannual premium to be amortized. The schedule for the first four interest payments would be as in Exhibit 1, above. At maturity, T will have reduced the basis of the TIPS by $7,787 ($115,787 – $108,000) as a result of amortizing the bond premium.

Amortization of Secondary Market TIPS Discount

If TIPS are purchased in a secondary market at a price below their adjusted principal, the holder reports accrued market discount as ordinary interest income, either annually or when the bond matures or is sold. If the holder does not report the accrued market discount until the bond matures or is sold, a ratable (straight-line) method is used to compute the accrued discount (Sec. 1276(b)(1)). Under the ratable method, any gain recognized when the bond either matures or is sold is first reported as ordinary interest income to the extent of the accrued market discount (Sec. 1276(a)(1)). Alternatively, the holder reports the accrued TIPS discount annually as ordinary interest income using the constant-yield method (Sec. 1276(b)(2)). Of the two methods, the ratable method is normally used because it allows the taxpayer to postpone reporting the accrued discount as income until the bond matures or is sold. With the ratable method, the holder calculates the accrued discount by multiplying the market discount by a ratio that is calculated by dividing the number of days the taxpayer has held the TIPS by the number of days after the taxpayer acquired them up to (and including) the date of their maturity (Sec. 1276(b)(1)). The amount of market discount is determined by assuming that the adjusted principal at the date of purchase is equal to the amount payable at the maturity date (Regs. Sec. 1.1275-7(f)(3)).

Example 6: N purchases TIPS in the secondary market with an original issuance price of $10,000 on October 15, 2007, for $9,500. The adjusted principal at the purchase date is $10,700. The secondary bond discount is $1,200 ($10,700 – $9,500). The maturity date is October 15, 2010, or 1,096 days from the purchase date. On October 14, 2008, or 365 days after the purchase, N sells the bonds for $10,400. The adjusted principal at the sale date is $11,000, an increase of $300 in adjusted principal since the purchase date. N’s basis in the bonds at the time of sale is $9,800 ($9,500 original purchase price + $300 increase in adjusted principal). The overall gain is $600 ($10,400 selling price – $9,800 adjusted principal). Under the ratable method, the accrued discount since purchasing the bonds is $400 ($1,200 secondary bond discount × 365 ÷ 1096 days). Of the $600 in overall gain, the $400 accrued discount will be ordinary income and the remaining $200 will be capital gain, both of which will be reported when the bond is sold.

TIPS Held in Taxable or Retirement Accounts

Generally, a retiree will want to hold his or her most tax-efficient assets in a taxable account and the least tax-efficient assets in retirement accounts. TIPS are clearly tax inefficient compared with equities because equities held for more than one year and qualified dividends from equities are taxed at long-term capital gain rates (Sec. 1(h)). In addition, gains on equities are postponed until they are sold.

From a tax-efficiency standpoint, TIPS should be viewed as being in the same category as other federally issued bonds and other federal debt instruments (not including Series I and EE savings bonds). They are taxed differently than other federal debt instruments, in that a cash-basis holder of these bonds may elect to defer recognizing the interest income until the bond matures or is redeemed (Sec. 454(a)). The TIPS holder is immediately taxed on the real return and the portion of the return that compensates the holder for inflation—the adjustment to principal. The conventional Treasury bond’s entire nominal interest, which consists of both a real interest component and an inflationary expectation component, is also immediately taxed. While TIPS, in contrast to conventional Treasury bonds, do not provide immediate cashflow to pay the taxes on the return’s inflation component, in the unlikely event the cashflow from the TIPS is insufficient to pay the taxes (see discussion below), the TIPS holder can always liquidate a portion of the TIPS holdings in order to pay the remaining taxes.

Arguably, TIPS and other federal debt instruments are more tax efficient than private-sector debt instruments such as corporate bonds, money-market funds, and certificates of deposit because the former are not taxed at the state or local level. This tax advantage is lost in a retirement plan. Therefore, a retiree will generally want to place assets in retirement accounts in the following order: first, private-sector fixed-income assets (e.g., corporate bonds, corporate bond funds, money-market funds, and certificates of deposit); second, federal debt securities (TIPS, TIPS funds, regular Treasury bonds, and Treasury bond funds); and, last, equities (stocks and stock funds).

Example 7: D holds 2/3 of her assets in retirement accounts and 1/3 in taxable accounts. Her retirement portfolio consists of 1/3 in TIPS, 1/3 in corporate bond funds, and 1/3 in equities. D would allocate all of the corporate bond funds and TIPS to the retirement account and the equities to her taxable accounts.

Example 8: Assume the same facts as in Example 7, except that D holds 1/3 of her assets in retirement accounts and 2/3 in taxable accounts. D would allocate all of the corporate bond funds to retirement accounts and the TIPS and equities to her taxable accounts.

TIPS After-Tax Returns in a Taxable Account

Exhibit 2 compares the after-tax returns for TIPS held in a taxable account assuming different real returns, annual inflation increases (which will translate to upward taxable adjustments in principal), and tax rates. Real returns are varied from 1.5% to 4.5%. This range represents the historical range for longer-term TIPS.

Inflation increases of 1%, 2.5%, 5%, and 10% are assumed. Many economists believe that the yield spread between the nominal rates for conventional Treasury bonds and the real rates for TIPS is a reflection of what the market expects inflation to be in the future. See, for example, a speech by the president of the Federal Reserve Bank of Richmond in which he discussed the usefulness of the TIPS spread as a measure of inflation expectations.⁹ Currently, this yield spread is around 2.5%. An inflation rate of 10% would be considered unlikely, at least in the near future. However, in the late 1970s and early 1980s, inflation rates approached or exceeded 10%.

Tax rates are assumed to be either 15% or 28%. A 15% rate is probably the most common tax rate for retirees. However, well-to-do retirees will have rates of 28% or even higher.

Based on present circumstances, a combination of a 15% tax rate, a real rate of 2.5%, and an inflation rate of 2.5% represents a realistic scenario. According to Exhibit 2, a combination of these three variables generates a 1.75% after-tax real return. This might be an acceptable return for some retirees. At a 28% tax rate, however, assuming again a 2.5% real rate and a 2.5% inflation rate, the after-tax real return is a more modest 1.1%. If a 28% rate is coupled with a 10% inflation rate and a 2.5% real rate, the real return is actually negative.

Holding TIPS Directly in a Retirement Account

Holding TIPS directly in a retirement account instead of through mutual funds allows the holder to eliminate mutual fund charges and to lock in a predetermined real rate for a longer period of time. Normally, in order to directly hold TIPS in a retirement account, the holder must establish a self-directed brokerage account within an IRA because most employer-sponsored plans such as Sec. 401(k) plans do not offer a self-directed brokerage account as an option.

Series I Savings Bonds Versus TIPS

The total return for Treasury-issued Series I savings bonds (I bonds), like TIPS, is made up of two components—a real interest rate component and an inflation component based on the percentage change in the CPI-U (variable rate).¹⁰ However, unlike the real rate component of TIPS, which is market based, Treasury sets the I bond real rate. While this real rate stays the same over the life of the bond (which is up to 30 years), the variable rate inflation component varies every six months.

Unlike TIPS, all of the interest earned on the I bond is tax deferred until it is redeemed. At the taxpayer’s election, the accrual method may be adopted for reporting the interest earned. If this method is adopted, however, it must be used for all savings bonds currently or subsequently owned by the taxpayer (Sec. 454(a)). As a trade-off to the tax-deferral advantage over TIPS, the real rate for the I bond is normally less than it is for TIPS. Currently, the real interest rate on the I bond is set at 1.4%. Also, if I bonds are cashed in without being held for at least five years, they lose three months of interest, and they must be held at least six months before they can be redeemed. No more than $30,000 of I bonds (per Social Security number) may be purchased annually.

Given the similarities between TIPS and I bonds, a holder needs to determine which type of bond makes the most economic sense. Before retirement, when someone is accumulating assets (the accumulation phase), TIPS will always be the better choice in a retirement account, as they would be expected to generate a higher return and the tax deferral of I bond interest is not an advantage. However, whether TIPS or I bonds are best held in a taxable account during the accumulation phase depends primarily on the holder’s tax rate, the real return difference between I bonds and TIPS, and the length of the holding period. A lower tax rate and a relatively large real return difference between I bonds and TIPS favors TIPS; a higher tax rate and a relatively small real return difference favors I bonds. Also, a longer holding period favors I bonds because this allows more time for their tax-deferral advantage to overcome their lower yield.

During retirement, TIPS are generally favored because the real interest amount from TIPS is available as a source of ongoing cashflow to meet retirement expenses. In contrast, I bonds do not provide any cashflow from either of their return components until the bonds are cashed in. As a result, a retiree must redeem the I bonds on an ongoing basis. In so doing, the retiree loses the I bond tax-deferral advantage over TIPS, and if the retiree redeems the bonds before holding them for at least five years, he or she loses three months of interest.

TIPS Held in a Taxable Account

There will be circumstances in which a retiree is not in a position to place TIPS in a retirement account. Many retirees will not have an employer-sponsored defined contribution plan such as a Sec. 401(k) or an IRA.

If retirees need to purchase TIPS for taxable accounts, they should consider strategies to mitigate the negative impact of income taxes on the after-tax return. One strategy involves purchasing TIPS in the secondary market at a discount and deferring the accrued market discount until the bond matures or is sold. Another is to sell TIPS that have declined in price, due to an increase in interest rates, in order to recognize a capital loss. To maintain the TIPS position, retirees can purchase new TIPS, keeping in mind the wash sale rules under Sec. 1091. Finally, in some cases, it might make sense to sell appreciated TIPS at a long-term capital gain in order to reduce subsequent interest income by purchasing similar bonds at a market premium. Each of these strategies is explained below.

Purchasing TIPS at a Discount

As discussed, if TIPS are purchased in a secondary market at a price below their adjusted principal, the holder may defer reporting the accrued market discount until the bond matures or is sold. This opportunity to defer a portion of interest income until a later date has the most potential value forTIPS with larger market discounts (as a result of a greater disparity between the current yield to maturity and the original stated interest rate) and with longer remaining maturity dates.

Example 9: Retiree P, for his taxable account, purchases in the open market TIPS selling at par. Both the stated interest rate and constant yield for the bond are 3%. The bond matures in 15 years. The principal is adjusted upward each year by 3% to account for increases in the CPI-U. His yearly interest income would therefore be 6%. P has a marginal tax rate of 15%. For each year, as long as the bonds are held, the after-tax return will be 5.1% [6% – (6% × 15%)].

Example 10: Assume the same facts as in Example 9, except that P purchases TIPS in the open market at a market discount. The stated interest rate is 2% and the constant yield to maturity is 3%. P elects to defer reporting the market discount until the bond matures or is sold. After five years, his TIPS holdings are sold. Assuming a discount rate of 6%, P’s annual after-tax return would be 5.14% [5% – (5% × 15%)] + [1% – (1% × (15% ÷ {1 + . 06}5))], an increase in yield of .04% compared with purchasing the bonds at par. If instead P sells the bonds after a 10-year holding period, the after-tax return increases to 5.17% [5% – (5% × 15%)] + [1% – (1 × (15% ÷ {1 + .06}10))], an increase in yield of .07%. Finally, if he holds the bonds to maturity, 15 years from the date of acquisition, the after-tax return is 5.19% [5% – (5% × 15%)] + [1% – (1 × (15% ÷ {1 + .06}15))], an increase of .09%.

Example 11: Assume the same facts as in Example 10, except that now P purchases TIPS with a greater market discount—a stated interest rate of 1.5% but a constant yield to maturity of 3%. If the TIPS are sold after five years, the after-tax return will be 5.16% [4.5% – (4.5 × 15%)] + [1.5% – (1.5% × (15% ÷ {1 + .06}5))], an increase in yield of .06% compared with purchasing the bonds at par. If the bonds are sold after a 10-year holding period, the after-tax return increases to 5.2% [4.5% – (4.5% × 15%)] + [1.5% – (1.5% × (15% ÷ {1 + .06}10))], an increase of .10% over par, and if the TIPS are cashed in at maturity, 15 years after their acquisition, the after-tax return will be 5.23% [4.5% – (4.5% × 15%)] + [1.5% – (1.5% × (15% ÷ {1 + .06}15))], an increase in yield of .13%.

Recognition of Capital Loss

If interest rates increase after particular TIPS are purchased, the price of the bond will fall below its adjusted principal and the holder will have the opportunity to sell the bond at a capital loss. The capital loss may be used to offset capital gain and up to $3,000 of ordinary income in a given year (Sec. 1211(b)); any unused capital loss is allowed to be carried forward (Sec. 1212(b)).

To maintain the same level of investment in TIPS, the holder will normally want to immediately purchase the same amount of TIPS that were sold. However, if TIPS (as is true with any security) are sold at a loss and immediately repurchased, the wash sale rules apply. Under these rules, if a holder purchases a “substantially identical security” within a 30-day period either before or after the sale of that security at a loss, the loss from the security’s sale is disallowed (Sec. 1091(a)). Therefore, to recognize the loss, the holder should generally wait at least 31 days before purchasing identical TIPS.

Alternatively, it is not necessary to wait 31 days before repurchasing if the holder does not purchase substantially identical TIPS. For the repurchase of TIPS (or any other bond) to not be considered substantially identical, the TIPS sold must have one or more material differences from the purchased TIPS. Different issue dates or interest payment dates are not considered material differences, but a significant difference in maturity dates between the old and new bonds probably will be considered material.¹¹

Long-Term Capital Gain Versus Interest Income Reduction

When the market interest rate for bonds of comparable risk declines, the market price of TIPS will increase so that their effective yield is equal to the market interest rate of comparable bonds. When this occurs, the holder can sell the bond at a long-term capital gain, purchase a comparable bond selling at a premium, and deduct the premium on a dollar-for-dollar basis against the coupon payments. This allows a bondholder to trade off the immediate recognition of a capital gain taxed at a lower rate for a reduction in interest income taxed at ordinary rates. Because the premium is amortized over the remaining life of the bond, from a present-value standpoint, the shorter the length to maturity of the bond, the more valuable the strategy.

Example 12: Retiree G, who has an ordinary tax rate of 28%, purchases $100,000 of newly issued TIPS with a stated rate of 3%. Over the next few years, market interest rates on comparable bonds decline. As a result, when the adjusted principal of the TIPS is $110,000, the fair market value is $120,000. G subsequently sells the bonds and recognizes a long-term capital gain of $10,000 ($120,000 – $110,000). G then purchases other TIPS with a stated rate of 3%, a remaining maturity length of 10 years, and a premium of $10,000. G amortizes the $10,000 over a 10-year period to offset the 3% stated interest rate. The straight-line method (instead of the constant-yield method) is used to amortize the $10,000, and a 6% discount rate is assumed. The immediate tax cost as a result of selling the original TIPS would be $1,500 ($10,000 long-term capital gain × 15% rate). The tax savings by amortizing the bonds over a 10-year period would be $2,060 [$10,000 (premium amount) ÷ 10 years (remaining maturity) = $1,000 (annual write-off against stated interest); $1,000 × 28% regular tax rate = $280 annual tax savings; $280 per year discounted at 6% per year over 10 years = $2,060]. The net tax savings would be $560 ($2,060 tax savings from amortizing the premium – $1,500 tax cost from selling the original bonds).

Example 13: Assume the same facts as in Example 12, except the new TIPS have a remaining maturity of five years. The tax savings generated by amortizing the bonds over a five-year period would be $2,359 [$10,000 (premium amount) ÷ 5 years (remaining maturity) = $2,000 (annual write-off against stated interest); $2,000 × 28% regular tax rate = $560 annual tax savings; $560 per year discounted at 6% per year over five years = $2,358]. The net tax savings would be $858 ($2,358 tax savings from amortizing the premium – $1,500 tax cost from selling the original bonds).

Conclusion

Social Security payments will provide an insufficient retirement income stream for most retirees, and an increasingly smaller percentage of the population will have a defined-benefit plan at retirement to supplement their Social Security income. Consequently, a critical issue for most soon-to-be retirees is how to tap their assets to generate a lifelong income stream that will help cover their current expenses and keep up with inflation. TIPS represent a conservative retirement investment that can meet these objectives and also allow retirees to bequeath at least a portion of their assets at death.

Ideally, TIPS should be held directly in a Roth or traditional IRA account, and only the real interest earned should be spent. If individuals do not have IRA accounts in which to hold TIPS or are holding less-tax-efficient assets in these retirement accounts (such as corporate bonds), it is necessary to hold TIPS in taxable accounts. Even when held in taxable accounts, as long as the inflation rate is confined to the long-term historical average of 2.5%–3% per year, the retiree should be able to earn a positive after-tax real rate of return. To mitigate the impact of federal income taxes when TIPS are held in taxable accounts, a retiree should consider such strategies as purchasing TIPS in the secondary market at a discount in order to defer reporting the market discount, recognizing capital losses if the price of the bond falls below its adjusted principal, and recognizing long-term capital gain to offset subsequent interest income.

For more information about this article, contact Prof. Toolson at toolson@wsu.edu.

Notes

¹ An annual adjustment is made to the Social Security payment based on changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

² Social Security Online

³ “Covet Thy Neighbor’s . . . Pension? Public vs. Private,” Fedgazette, May 2006

⁴ For a discussion of dividends as retirement income, see Craig and Toolson, “Formulate a Tax-Efficient Dividend Strategy for Retirement,” Practical Tax Strategies (March 2005): ¹68–75.

⁵ General information about TIPS, including how to acquire them directly from the U.S. Treasury, can be found at TreasuryDirect.

⁶ Wall Street Journal, Markets Data Center, Treasury Quotes, http://online.wsj.com/page/mdc/2_0500-tsyquote-10.html and http://online.wsj.com/mdc/public/page/2_3020-tips.html?mod=topnav_2_3024.

⁷ TIPS funds are available with annual expense ratios as low as .2%.

⁸ For empirical evidence of the diversification benefits of TIPS, see Kothari and Shanken, “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal (January/February 2004): 54–70; and Roll, “Empirical TIPS,” Financial Analysts Journal (2004): 31–53.

⁹ Remarks by Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond, at New York University (5/22/07).

¹⁰ For information on the mechanics of I bonds, see 31 CFR §359 and www.savingsbonds.gov.

¹¹ Rev. Rul. 58-210, 1958-1 CB 523. For a detailed discussion of capital losses, see Craig and Toolson, “Planning for the Effective Use of Capital Losses,” Journal of Financial Service Professionals (September 2002): 51–63.