Among the various financial worries that afflict yours truly these days are the double-edged threat of inflation and taxes. One attacks from the left, the other from the right. Ideally, there are some crumbs left over after these two demons have had their way with an otherwise profitable investment. But there are no guarantees, especially for taxable accounts holding asset classes that aren’t likely to deliver stellar gains in any given year, even under the best of circumstances.
In particular, we’re thinking of inflation-indexed Treasuries, or TIPS. In concept, TIPS are great. Owning the securities allows for the locking in of a real, or inflation-adjusted yield for the life of the bond. The problem is one of how the government taxes TIPS. If inflation jumps sharply, so too will the tax bill that year. That’s because the interest payment on TIPS, along with any rise in principal (triggered by a rise in the consumer price index), is treated as income. The higher principal is taxable in the year it occurred, even though it won’t be realized until the bond matures or the investor sells–phantom income, as it’s known.
For that reason, many investors hold TIPS and TIPS-focused mutual funds in tax-deferred accounts. But for some, particularly those lucky enough to be in the high-net-worth category, a fair chunk of the portfolio may be taxable. For investors considering owning TIPS in a taxable account, there are some recent innovations to consider, such as the JPMorgan Tax Aware Real Return mutual fund.
Minimizing the tax man’s bite and hedging inflation via TIPS in taxable accounts are also among the specialties of the bond shop Samson Capital Advisors. Your editor recently interviewed one the principals on the issue of TIPS and taxes. The Q&A appears in the April issue of Wealth Manager. And now, through the miracle of the Internet, we also offer a copy of the conversation here. Death and taxes may be inevitable, but delaying both ranks fairly high as one of the more productive uses of time. For some insight into the latter on the matter of TIPS, please read on….