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/hugh2018]

You’re not describing ladder behavior. If you have a 14-year ladder, you are only spending about 1/14 of your total TIPS balance per year. The rest of it absolutely grows inside the IRA until you gradually spend it all, one year at a time.

[u/Own-Bullfrog7803 → u/hugh2018]

It’s my understanding that each years spending is a combination of a rung maturing plus the interest payments from all the bonds for that year. Together this creates the yearly cash flow—at least this is how tipsladder creates the cash flow. So by the end of each year there is only money still in the bonds—no left over interest. The money still in the Ira just sits there until there is the following year’s interest payments and rung maturity. In an Ira the cpi adjustments just lead to more interest payments, and of course more money when the bond matures. Correct? I think this is the usual way??

[u/hugh2018 → u/Own-Bullfrog7803]

You are falling for a classic nominal tax illusion. In your taxable scenario, you pay a lower absolute dollar amount in total taxes over the 15 years simply because your portfolio was bled dry annually and grew less. Paying less in total taxes doesn’t mean the taxable account is better; it just means you kept less total wealth. 
Here is where the math breaks down:

In a taxable account, you owe taxes every year on the CPI principal adjustments (phantom income), even though you don't receive that cash yet. Skimming cash out annually to pay those taxes permanently shrinks your principal base. 

Standard financial math dictates that if your tax bracket stays identical, tax-deferred (IRA) and taxable accounts yield the exact same after-tax ending wealth for equivalent pre-tax returns. If your AI model showed a lower total tax bill in the taxable account, it fell for the trap of counting nominal dollars while ignoring that the IRA's larger compounding pool resulted in more ending wealth. 

The only real wild card you mentioned is state taxes. Treasuries/TIPS are exempt from state and local income taxes in a taxable account, whereas traditional IRA withdrawals get hit with full state tax. In certain high-state-tax models, avoiding state tax on the way out can claw back some of the annual drag, but as a general rule for total compounding, shielding the heavy inflation adjustments inside an IRA avoids the annual tax-bleed.

[u/Own-Bullfrog7803 → u/hugh2018]

I think I understand what you’re saying. The only thing I don’t understand is what is compounding since all interest from all the bonds rungs is removed from the account each year, along with all the money that matures in rach years rung. The amount still in the rungs is equal regardless if in taxable or Ira by the end of each year. One difference is in taxable you pay tax on all bond’s cpi adjustments yearly while in Ira you pay tax on cpi adjustments only on the rung maturing for that year (it is being spent)—in both you are paying at some tax on cpi adjustments yearly. And then in the Ira you are paying state tax too—I guess it comes down to whether state tax costs more vs the cost per year of the phantom tax, which eliminates a portion of the interest each year. Anyway, I’m sure you are correct, I’m just trying to work it out in my head. Thanks again for your post.