Inflation-Proof Your Retirement Savings Now (From The Wall Street Journal)
~ Monday, October 23, 2023 Blog Post ~
By Laura Saunders, October 20, 2023
Many of Uncle Sam’s bonds linked to inflation, called TIPS, performed horribly last year. It’s time to give them another look.
It’s hard to find a more confusing “safe” investment than the government bonds called TIPS, for Treasury inflation-protected securities — and that includes the taxes on them. But people who avoid them now could be making a mistake, especially if they’re facing retirement.
No wonder investors are bewildered. TIPS say they offer inflation protection, but last year, when inflation roared, many holders of funds with longer-term TIPS had steep negative returns. That’s because TIPS, like other bonds, suffer when interest rates rise.
Many investors fled, pulling about $42 billion out of TIPS funds between April 2022 and Sept. 30 of this year, according to Morningstar Direct.
Yet now that inflation has cooled, TIPS yields are shining. What’s known as the real yield on 10-year TIPS was recently about 2.5%, the highest in years. If investors hold to maturity, they’re guaranteed that annualized return, because the principal of the bond is adjusted for inflation.
Including the inflation adjustment, the total yield on 10-year TIPS was recently about 4.9%, while the yield on the traditional 10-year Treasury note was flirting with 5% — but it’s not adjusted for inflation. So TIPS will do better than traditional Treasurys if inflation averages more than about 2.4% over the decade.
Also confusing are TIPS taxes. Because these bonds throw off phantom income, they often generate annual tax bills without cash payouts to cover them. This makes some investors shun them.
If you’re one of the shunners, think again. Right now, say some advisers, individual TIPS offer remarkable opportunities to investors who want inflation-proof chunks of cash with increases in spending power, such as for retirement.
One of these advisers is Allan Roth, a CPA and the founder of Wealth Logic, an advisory firm. Putting his money where his mouth is, he recently built a $1 million, 30-year ladder of individual TIPS for his own family. As each slice matures, the principal and income will provide inflation-adjusted cash equal to about $45,000 a year in today’s dollars, he says.
Roth knows he’s giving up the potential for more capital appreciation from investments like stocks. But he wants to lock in future spending power on these assets. For growth, he’ll look to a separate slug of stock-index funds.
“It’s scary to spend down a portfolio, especially in a down market, but the ladder gives me a license to spend,” he says. “It’s the only investment strategy I’ve found that makes economic sense and also feels great.”
Roth adds that given current TIPS yields, his ladder is enabling a withdrawal rate of 4.5% pretax for 30 years when held to maturity. This is more than the 4% retirement withdrawal benchmark. The fees are also minimal, and he says the tax on phantom income is “an annoyance, not a deal breaker.”
That said, TIPS are complicated. Here’s more to know.
The basics
TIPS are U.S. government debt designed to keep pace with inflation. TIPs have two parts — principal, and a coupon that pays interest.
TIPS’ principal adjusts up or down based on the consumer-price index known as the CPI-U. The interest rate on the coupon is set at auction when the bond is first sold, but the amount of interest fluctuates with the changes to the principal. With so many moving parts, TIPS can be volatile.
Availability
Unlike I bonds, the popular inflation-adjusted U.S. savings bonds, TIPS are available in large quantities and can be bought through brokerage firms as well as the government’s TreasuryDirect.gov website. Also, unlike I bonds, they are tradable and can be packaged into mutual funds and exchange-traded funds.
TIPS come in durations of five, 10 and 30 years, and the minimum purchase is $100 at TreasuryDirect. Many maturities are available in the secondary market through brokers, including Vanguard, Fidelity and Charles Schwab.
Tax treatment
When TIPS are held in taxable accounts, both the coupon interest and the inflation adjustment are federally taxable at ordinary-income rates, but they are exempt from state and local taxes.
TIPS interest is paid in cash, while the income from the inflation adjustment isn’t. An investor must come up with the cash to pay this tax.
How much is this phantom income? Tim Steffen, a CPA and director of advanced planning at Baird, crunched numbers based on information at TreasuryDirect.
He says that for $10,000 of 30-year TIPS issued on Feb. 1, 2019 with a 1% coupon, the principal adjustment generated income of about $226 for 2019; $122 for 2020; $640 for 2021; $854 for 2022, and $331 through Sept. 30, 2023. Although the coupon is fixed at 1%, the interest paid has grown with the principal.
Steffen notes that the tax paid on TIPS’ phantom income raises its cost basis, so at maturity most of the tax due on the inflation adjustments has been paid.
If TIPS in a taxable account are bought at a discount in the market, there’s another layer of complexity. Tax is due at ordinary income rates on the market discount, but this can be paid each year or deferred until the bond matures or is sold. Deferring this tax won’t alter the tax due either on the coupon interest or the inflation adjustments, but it can help with cash flow, says Steffen.
Individual TIPS or TIPS funds?
Investors who want to preserve and grow a defined amount of spending power for a certain period likely should choose individual TIPS and hold them to maturity, says Roth. He built his ladder using securities from Fidelity and Vanguard’s platforms.
In addition, iShares recently launched TIPS defined-maturity ETFs, making it easier to assemble a TIPS ladder of up to 10 years. Two independent sites, EyeBonds.info and tipsladder.com, offer free tools for TIPS investors building ladders.
For investors who aren’t certain they can hold to maturity, TIPS funds are an alternative. They are professionally managed, come in different flavors targeting particular maturities and are typically easier to buy, sell and manage than individual TIPS.
Retirement account or taxable account?
Both individual TIPS and TIPS funds can be held either in taxable accounts or tax-deferred retirement accounts, although TreasuryDirect doesn’t allow retirement accounts.
But there’s a trade-off: The tax on TIPS income in retirement accounts is deferred until withdrawal. This solves the phantom-income problem, but these savers lose the benefit of the state-tax exemption. Withdrawals from these accounts are taxed as ordinary income.
This loss won’t matter to residents of no-tax or low-tax states. Residents of high-tax states like New York, California and New Jersey should consider holding TIPS in taxable accounts.
Source:
https://www.wsj.com/personal-finance/tips-treasury-inflation-protected-securities-2023-7886474e
