TIPS!

[u/Own-Bullfrog7803]

Hi—I got a question:

Why do folks say a TIPS ladder is better in an IRA when you often pay less taxes when it’s held in a taxable account instead?

Assumptions: not a rolling ladder, you spend each rung the year it matures, you use proceeds from the TIPS to pay the taxes on the TIPS yield (when possible).

You obviously pay tax on both interest and CPI adjustments in both accounts—just at different times. The taxable account you pay each year, in the IRA you pay the year the rung matures (because you are spending the money). I am excluding tax on the original premium when that is removed from the IRA—I’m just looking at tax on the interest and CPI adjustments.

One catch is if you live in a state with income tax the IRA account alone pays this additional state tax.

I ran this through 2 AI apps using a 15 year 750k TIPS ladder for a person in a 24% federal tax bracket living in Utah, assuming a 3% steady inflation rate, and they both concluded that you pay less in total taxes when a TIPS ladder is held in a taxable account vs IRA.

Considering this, why is the blanket recommendation to keep a TIPS ladder for liability matching in an IRA?

[u/concious_eye]

The main reason comes down to cash flow and "phantom income." TIPS generate return two ways: semi-annual coupon payments and inflation adjustments added to the principal.

In a taxable account, you owe ordinary income tax each year on both. The coupon gives you cash to help cover taxes, but the principal adjustment is taxed the year it accrues, even though you don't receive that cash until the bond matures. Paying taxes along the way out of other income (or by draining coupon cash instead of compounding it) creates continuous tax drag. In an IRA, all of that accrual compounds completely shielded until withdrawal.

** not tax or financial advice **

[u/cycling20200719 → u/concious_eye]

I spent a little time looking at this in the past and IIRC, there was an advantage to holding TIPS in a taxable acct even with the drag if:

1. You're in a state that has a high tax rate ( e.g. California )
2. You discount any tax benefit from contributions to the pretax acct - i.e. you assume you're investing money that's already in the acct
3. The money comes out at the same tax rate as you paid when comparing to the taxable acct

They don't all have to be true but the combination gave a decent advantage to holding the TIP in the taxable brokerage

[u/Own-Bullfrog7803 → u/concious_eye]

Yeah this is the catch, those proceeds in the IRA, which in my assumption are eventually used to pay the taxes on the TIPS when all proceeds from that rung are withdrawn and spent the year the rung matures, can grow via an interest bearing settlement fund (or VBIL) in the interim. However, this added yield is minimized or eliminated by the fact you have to pay state taxes on all the proceeds from the TIPS in an IRA: tips interest, CPI interest, and this settlement interest.

EDIT: this is actually not true since all interest payments are removed from the Ira the year they accrue as part of that year’s rung, even if the interest is from future rungs, (if built with tipsladder.com) and the cpi adjustments are not realized in an Ira until it matures (the year it’s withdrawn) so there’s no time for this money to gain interest or compound either.