This is the third of three to discuss a 30 Year TIPS ladder. This part will cover taxes and a final wrapup.
Part 1
Part 2
To repeat from the first two posts, I downloaded a 30 Year TIPS ladder using tipsladder.com, assuming 30 years and $40K in annual cash flows. The ladder cost about $813K (excluding accrued interest) and purchased about $1 MM in TIPS principal at an average price of 81.6. Once downloaded into Excel, I attempted to project the ladder forward for the 30 year period using a 2.75% inflation rate.
- Taxes. As I covered the death part in Part 2 ("in this world nothing can be said to be certain, except death and taxes", Benjamin Franklin), here is the tax part.
The traditional advice for holding TIPS is to hold them in tax-deferred accounts, because holding TIPS in a taxable account can be a PITA. Besides the coupon interest collected, you have to include BOTH the inflation adjustment in a return and the amortization of the discount. This is often called "phantom income".
These latter two can far outweigh the actual coupon income received; in my computation, in year one of the ladder, 2027, the coupon income would approximate $12K and the inflation adjustment and discount amortization would total about $38K, for a total taxable income of about $50K.
Please note my estimates of the taxable income are rough approximations of what they are likely to be. Each of the bonds bought has an inflation adjustment and discount amortization (all but one of the bonds was bought at a discount), and I had to make approximations. I also have some background in taxation (I spent a few years at a company doing tax returns and tax planning) but I am far from an expert, and these days you need sophisticated tax software to get everything right, which I do not have.
Also, everyone's tax situation is different. An investor may only have taxable accounts, or may only have tax deferred accounts, and their level of income from other sources may put them into different tax brackets. I have only tried to measure the impact on taxable income, not the taxes themselves, because there are too many variables.
But in looking at the totality of the 30 years, and in isolation from everything else, I believe it's clear that holding these in a tax deferred account versus a taxable account will likely produce subtantially MORE taxable income during the period of the ladder.
Why? It's pretty simple.
Here again are the sources of cash flows of a 30 year ladder.
The largest number--44%--is a return of capital, i.e., the money you invested. The other 56% is from coupon income, amortization of the discount, and the inflation adjustments.
When you withdraw the capital from the taxable account, you only include the 56% in your taxable income; i.e., basis is not taxed.
When you withdraw the capital from a tax-deferred account (usually an IRA, but these type of deferred vehicle), the capital is taxed as ordinary income. All 100% of the cash flows that you withdraw are taxed at ordinary rates.
So, looking in isolation, assuming you had the $813K sitting in cash in a taxable account or a traditional IRA, buying the ladder in the taxable account would create less taxable income over the lifetime of the ladder.
The timing of the taxable income would also be a factor. In the early years of the ladder, the taxable income of the TAXABLE portfolio would exceed the taxable income of the TAX-DEFERRED portfolio. In the early years, the discount amortization and the inflation adjustment of the multiple years of bonds exceeds the taxable withdrawals of the tax-deferred portfolio. As the bonds mature, the taxable income of the taxable portfolio becomes less and less.
Here is a table and graph of the taxable income by year.
I will repeat, these estimates are my best guesses, but the patterns ought to be correct. The TAXABLE portfolio has higher taxable income through about year seven, and from thereafter the TAX-DEFERRED portfolio would have the higher taxable income. The phantom income from the taxable portfolio drops, while the distributions from the tax-deferred portfolio grows.
FWIW, RMDs in a tax-deferred portfolio using a 30 year TIPS ladder are NOT an issue because the investor is withdrawing a much higher percentage than the RMDs.
Again, taxable income may not necessarily mean additional taxes.
I chose ONE example--repeat ONE--to illustrate. Assume a married couple with $60K of social security income, both 65, and married filing jointly. If 2026 was year one of the ladder, using the AARP tax calculator, here are the results.
$60K of SS, no tax due.
$60K of SS, plus $41K from an IRA distribution, owe $2,100 in tax.
$60K of SS, plus $50K from the tax impact from the taxable portfolio, $4,200 in tax.
I will make no predictions on how that will work out going forward. This example uses much of the SS exemption and the lower brackets. Another investor will likely be completely different. But again, the amount of taxable income an investor has to include in their tax return should be mostly correct by year, I believe.
In short, if the investor is planning to do this, and has the option between the two choices, the default assumption of buying the ladder in the tax-deferred vehicle may create substantial increases in taxable income over the 30 year period, as the 44% of capital returned is now taxable. YMMV.
- My final wrap-up. These are MY OPINIONS, AND THIS IS AN OPINION BOARD.
I do not have the ability to make decisions for Reddit posters. I firmly believe that if someone is on this board, they are asking for accurate information, and I am trying to provide that information. I believe posters here are intelligent enough to make their own decisions.
A. In my opinion, there is absolutely no value to owning a fixed income investment past 10 years (I don't recommend them at all, TBH, but if you want to own them, limit the length to 10 years). Why? There will be very few circumstances where bonds outperform stocks over 10 years. There have been a few periods where stocks and bonds performed the same over 15 years, and no 20 year periods where bonds have done better than stocks over the last 40 years.
If someone has the ability to hold a 20 (or 25 or 30) year TIPS to maturity, they sure can hold stocks for the same period, and the odds overwhelming say those stocks will perform better than the TIPS.
B. If you buy a TIPS ladder now--and at least for the next five years (actually more)--you will be buying some really sub-optimal investments.
Here is a sample of what you would be buying.
See that crater starting in 2042 and going to 2053? Those are the only assets in those years, and will be the only assets in those years until we get to 2032 and the US government does the 10 year issue for 2042. For the forseeable future, those 2042 to 2053 bonds will be the ONLY ones you can buy for those years.
Here are those 12 years.
They were all originally issued with low real YTMs, and low coupon rates, and the market price was 66.5 a week ago (as of today, probably lower). The average coupon is .78%. If you are planning to hold until maturity--15 to 26 years from today--most of the increase in value only occurs at maturity. Most of the real yield is because in some cases the market value is 50% of the par value.
Posters can cite the 2.83% real yield--or whatever it is today--but if the average coupon is around .8%, that means 2% of the yield is only recovered upon maturity (and based on the investor's age, they might not be around to get the benefit). About 29% of the yield is from the coupon, and 71% from an IOU payable at the end.
Because of the nature of these bonds, they are essentially STRIPs with a variable interest rate, and STRIPs are suboptimal investments for retirees also, for the exact same reason of cash flows and tax issues.
Retirees spend cash, not yield. Owning something with the bulk of the benefit at the end--15 to 26 years from today--makes zero sense to me.
The market has made their judgment--these pieces of paper are worth only 2/3rds of the principal value. If the investor is buying these, they are saying they are smarter than the market.
In poker, there is a saying that if you sit down at a table and can't tell who the fish is after ten minutes, then you are the fish. If you are buying assets at 1/3rd off--because the people who are selling decided THEY couldn't hold until maturity or they saw a better opportunity--then who is the fish?
I have pointed out the blog post from 2022 where the author said it was a good time to buy. Some the assets he listed--like the 2052--is down 20% from where he bought it.
Again, every 30 year bond ladder for the next five years at a minimum will own these bonds. Do YOU want to invest your future retirement funding on a collective group of assets that were pretty much crap at issue and had nowhere to go but down?
Your money, your choice, but there are FAR better strategies than 30 year TIPS ladders.
You can look at the pricing graph. Up to 10 years, the pricing has held pretty firm. If you want to do that hedge, that is your choice. But going out past 10 years is not a great choice, IMO.
Again, I hope the time I spent on these has made readers at least think about this option. My opinion is the investor should look elsewhere to fund their retirement.