30-Year TIPS Yield Nearly 3% Above Inflation. At 71, the Inflation Protection Itself Can Make More of His Social Security Taxable.

A 71-year-old retiree did what the textbooks suggest. He built a ladder of Treasury Inflation-Protected Securities in his brokerage account to keep inflation from quietly eating away at retirement. The timing looks unusually attractive. As of August 28, Treasury’s real-yield curve put 10-year TIPS at 2.42% and 30-year TIPS at 2.96%. Those are yields above inflation for an investor buying at current market prices and holding to maturity. That 2.96% is a real yield, meaning it sits on top of the inflation adjustment rather than competing with the inflation rate itself.

His Social Security check covers the essentials. The TIPS supply interest and inflation protection. Then tax season arrives. When inflation pushes up the principal value of TIPS held in a taxable account, the IRS generally taxes that increase in the year it occurs even though the retiree has not received the principal in cash yet. That “phantom” income can do something else too: make more of his Social Security taxable.

The Inflation Adjustment Lands on the Tax Return

TIPS have two moving pieces. They pay interest at a fixed coupon rate, but that rate is applied to principal that rises and falls with inflation. In a taxable account, both can create current federal taxable income. Treasury reports the interest, while increases in inflation-adjusted principal are generally reported as original-issue discount, or OID.

Suppose our retiree owns $200,000 of TIPS and inflation raises the principal by 3% during the year. That is roughly $6,000 of additional principal. He cannot spend that $6,000 yet. But it generally enters taxable income for the year. His tax basis in the bonds also rises by the amount included, preventing the same increase from simply being taxed all over again when the bonds mature. The problem is what that income can touch along the way.

Social Security Sees Income Early

Whether Social Security benefits are federally taxable depends partly on what is often called combined or provisional income: adjusted gross income (AGI), tax-exempt interest and half of Social Security benefits. For a single filer, the first threshold is $25,000. Above $34,000, as much as 85% of Social Security benefits can become taxable. For married couples filing jointly, those thresholds are $32,000 and $44,000.

The TIPS inflation adjustment feeds AGI. That means a retiree sitting close to one of those thresholds can have an inflation adjustment push additional Social Security into taxable income even though the principal increase itself never reached his checking account.

It is important to distinguish that from an 85% tax rate. At most, 85% of the Social Security benefit becomes part of taxable income and is then taxed at the household’s applicable rate. That is the tax torpedo retirees hear about. TIPS held directly in a taxable account can contribute to it. It is one of several IRS rules that quietly drain retirement accounts, and we mapped the rest in a free tax trap guide.

Timing Is Everything

The same TIPS held inside a traditional IRA do not generally produce a personal tax bill every year as principal adjusts for inflation. Instead, taxation generally waits until money comes out of the IRA. That can keep annual TIPS inflation adjustments from feeding the Social Security taxation formula while the securities remain inside the account. The trade-off is that eventual traditional IRA distributions are taxable income too.

For our 71-year-old, that deserves attention because required minimum distributions (RMDs) generally begin at 73. Once RMDs arrive, they can stack with Social Security, interest and other taxable income whether or not TIPS are involved. I Bonds have another useful distinction. Their interest can generally be tax-deferred until redemption or maturity rather than reported annually, although annual purchase limits make them a much smaller tool for someone building a large inflation-protected portfolio. The current composite rate for newly issued I Bonds is 4.26% through October.

Inflation Hedge Location Matters

Before buying the next rung of a TIPS ladder, look beyond the real yield and ask what the inflation adjustment will do elsewhere on the return.

1. Check where the TIPS are held. Individual TIPS in a taxable brokerage account can generate annual OID from inflation adjustments even before the principal is received.
2. Run the Social Security income calculation. Someone near the $25,000/$34,000 or $32,000/$44,000 thresholds has more reason to care about another few thousand dollars of taxable income.
3. Look ahead to RMDs. At 71, the current tax picture can change quickly once required retirement-account withdrawals begin.

TIPS are designed to keep inflation from shrinking retirement income. Holding them in the right account helps make sure more of that protection stays where it belongs.

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