The tax treatment of Treasury Inflation-Protected Securities (TIPS) can be daunting. With these bonds, the principal is increased to reflect inflation. Each year you are taxed on the inflation adjustment and the interest you receive, even though you’re only pocketing the interest.
For example, you might invest $20,000 in TIPS and get an $800 inflation adjustment this year as well as $500 in interest. You’d owe tax on a total of $1,300 in income ($800 plus $500) even though your only cash flow has been $500. (You won’t get the inflation adjustments until you sell or redeem the bonds.) This income is exempt from state and local income tax but you’ll owe federal tax at rates up to 35 percent
One solution to this problem is to hold TIPS in a tax-deferred retirement plan such as an IRA. You won’t owe any tax until money is withdrawn, which might be after you retire and are in a lower tax bracket. These withdrawals will be subject to state and local income tax, however.
