When TIPS aren't TIPS

[Maurice]

Has anyone given much thought to the risk of iBonds or TIPS held outside of a ROTH getting a negative real rate of return?

I've been doing the math on some inflation-hedging scenarios and it seems that if the inflation rate is high relative to the so-called "real" rates of return of these bonds (which is a distinct fear of mine moving forward) then your actual real rate of return can easily be negative (since you pay taxes on the inflation adjustment as well). The return rate can easily be negative even if you hold them in a traditional IRA. Only holding them in a Roth guarantees a positive rate of return.


For those of you that have TIPS, do you have then in a Roth? If not, is this high-inflation tax effect something you've given much thought to?

 

[twaddle]

Yup, you could conceivably pay more in taxes that the bond coupon pays you. Of course, you'd eventually get it all back in the form of the inflation-protected principal at maturity (which would already have been taxed).

Or you could buy a TIPS fund like VIPSX or the TIP ETF, which both pay out the inflation adjustment as part of the dividend.

And in either case, remember that TIPS are state tax-free. Unlike CDs and most taxable money market accounts.

 

[Maurice]

Of course, you'd eventually get it all back in the form of the inflation-protected principal at maturity..

Yes, but even still, this could easily represent a negative real rate of return. In fact, in the case of iBonds with a 1.3% fixed portion, I'd say negative real return is a serious possibility over the next decade or so.

And if the teens look anything like the 70s, TIPS outside of a Roth would also give a negative return.


So what's the answer? Hold TIPs in a Roth, crowding out capacity to hold (presumably) higher-earning assets in a tax-free account? (this seems unwise)

Or be prepared to sell your TIPs if inflation goes out of control, substituting with short-term bonds that (presumably) take higher inflation expectations into account?

Or something else I'm not thinking of?

Or should I calm down, put my trust in Bernanke and quit worrying so much?

 

[twaddle]

Forget the concept of "negative real return" for a bit, and just look at interest income and taxes. Let's imagine you're taxed at the 50% rate on interest income.

Let's say you have a choice between TIPS with a 2%+CPI yield and nominal treasuries with a 5% yield, both same maturity, same tax rate, same default risk.

To simplify, let's hold the TIPS bond via the TIP ETF, so you get the inflation adjustment as part of your dividend yield.

If inflation stays at a constant 3%, both bonds have the same yield, and both have the same tax hit.

If inflation goes to 10% a la the 70's, then the nominal bond still has the same 5% yield, but the TIPS went to 12%.

So, at a 50% tax rate, the after-tax yield on the nominal is 2.5%, and the after-tax yield on the TIPS is 6%.

As far as real return, you're right: the TIPS would give you a -4% real return, but the nominal bond would give you a -7.5% real return.

TIPS will always have a better return than the nominal treasury whenever the CPI > 3%.

I guess the moral of the story is that nobody in the 50% tax bracket should have any taxable bonds in their taxable accounts.

Thankfully, few retirees are in anything like a 50% tax bracket since we don't have much earned income. If you're in a high federal tax bracket, all of your bonds should probably be tax shelterd. I'm not sure why you distinguish between Roth and traditional IRA. The bonds will be fully tax sheltered in an IRA, but your IRA distributions are taxed as regular income no matter what the source (even stocks).

 

[Maurice]

I guess the moral of the story is that nobody in the 50% tax bracket should have any taxable bonds in their taxable accounts.

Thankfully, few retirees are in anything like a 50% tax bracket since we don't have much earned income. If you're in a high federal tax bracket, all of your bonds should probably be tax shelterd. I'm not sure why you distinguish between Roth and traditional IRA. The bonds will be fully tax sheltered in an IRA, but your IRA distributions are taxed as regular income no matter what the source (even stocks).

Yeah, thats the moral I've imbibed. The problem is, I have a relatively small percentage of my assets in tax advantaged accounts. I'd like to use them for other tax inefficient asset classes (say REITs) and for those with high expected returns over the next couple of decades.


Re the Roth vs. Traditional IRA - its a rather important distinction. If I buy 20 year tips in a traditional IRA I have the very same potential for negative real returns - its just that the negative return is unrealized until I withdraw the money. If I buy it in a roth I'm guaranteed the positive return.


Which leads me to my present conundrum - I've been investigating the possibility of using TIPS and iBonds to create a synthetic annuity, if you will, to provide a good chunk of my needed retirement income. This would allow me to reduce or even eliminate withdrawals from the rest of my portfolio in year that the market isn't doing well, and will also dramatically lower downside risk. The problem I'm discovering is it doesn't seem to make sense to do this unless it can be done in a tax free account. But thats a really scarce resource for me (maybe 16% of my total assets) so I'm really restricted in what I can do.

 

[ats5g]

Maurice,

A while ago, I created two spreadsheets for calculating the real after-tax values of TIPS and I bonds in taxable accounts:

After tax I bond values, and

I bonds vs. TIPS

They may or may not be helpful in your situation.

Also, I'm a little confused about this statement:

Re the Roth vs. Traditional IRA - its a rather important distinction. If I buy 20 year tips in a traditional IRA I have the very same potential for negative real returns - its just that the negative return is unrealized until I withdraw the money. If I buy it in a roth I'm guaranteed the positive return.

The money in the Roth is just the after-tax equivalent money of the deductible Traditional IRA [or 401(k)] money. For example, at a 25% tax rate, $7,500 in the Roth would be equivalent to $10,000 in the deductible Traditional IRA. Does this change your conclusion of buying the TIPS in the Roth vs. trad IRA?

FWIW, here a quick summary of a very good paper on Asset location: Wrong Place, Wrong Time: Asset mislocation could cost investors up to 20% of their after-tax returns, according to a new study

Personally, I think that given the very tax efficient vehicles for the higher expected returning assets [like small stocks, EM stocks, etc.] via index funds/ETF/TM funds, I don't think it makes much sense to put those in either Trad IRAs or Roth IRAs. For REITs, check out Bernstein's A limited case for Variable Annuities, which may have you considering Vanguard's VA REIT for REITs.

- Alec

 

[Independent]

Re the Roth vs. Traditional IRA - its a rather important distinction. If I buy 20 year tips in a traditional IRA I have the very same potential for negative real returns - its just that the negative return is unrealized until I withdraw the money. If I buy it in a roth I'm guaranteed the positive return.

It looks like we've got two posters who think there's a difference between Roth and traditional, and one who thinks they're the same.

I'll vote on the side that says there's a "guaranteed" positive real after-tax return on TIPS inside a traditional IRA, and it's the same return you get on a Roth. (I'm assuming the same marginal tax rates at the beginning and end of the time period.)

Suppose I have $1,000 in TIPS in the IRA today and I'm in a 30% marginal tax bracket. If I withdraw the money, I pay $300 in taxes and have $700 of after-tax spendable cash.

Now suppose I leave the money in the TIPS. Over the next n years, the CPI doubles, but the accumulated dollar value of the TIPS triples. I've got $3,000 inside the IRA. I withdraw it, pay $900 in tax, and have $2,100 of after-tax spendable cash.

Note the ATSC went from $700 to $2,100 while the CPI doubled. In constant dollars the ATSC went from $700 to $1,050, clearly a positive return. In fact, you gain 50% over n years.

With the Roth, you get the same percentage gain in after-tax spendable cash. If the $1,000 had been in the Roth, you would have had $1,000 of spendable cash by withdrawing today. Leaving it in the Roth results in $3,000 of nominal dollars after n years. That's $1,500 in constant dollars, for the same 50% over the same time period.

 

[bamsphd]

Has anyone given much thought to the risk of iBonds or TIPS held outside of a ROTH getting a negative real rate of return?

I have at least considered it. However, I still have a TIPS ladder in a taxable account because I don't have a more attractive alternative available.

I mainly console myself with the thought that if inflation gets high enough that my after tax real rate of return is negative, it will hurt, but not nearly as much as using a non-inflation adjusted ladder would have hurt!

The "better" my non-equity investments do, the more I will pay in taxes. About the only way I know of to avoid those taxes is to invest poorly!

 

[Maurice]

Alec - thanks for the spreadsheets, very useful.


Re Traditional vs Roth - I admit I was a bit myopic in my comment and was referring to my own case where traditional IRA is not pre-tax money. Therefore the difference is huge.


Having said that, I still see a difference between traditional and roth.

Lets take a concrete example.

Two investors, both in 35% tax bracket now and in 20 years.

Roth Investor - puts 1000 in a Roth IRA, pays 350 in taxes.

T-IRA Investor - puts the 1350 in a traditional IRA (assume pre-tax money)

Both buy 20 yr TIPS.

(two simplifying assumptions that should not effect illustrative nature of the below - inflation stays constant and coupons are reinvested at same rate)

Three scenarios - inflation at 3%, 5%, and 10%

Scenario A - 3% inflation

Roth Investor has $2,653.30 after 20 years (1000*[1+.02+.03]^20 )

His initial investment was 1350, so his CAGR is 3.44% (exp{ln[(2653/1350)/20}-1)


T-IRA investor has $3,581.95 after 20 years, pre tax. tax is 781.18 (.35*[3581-1350]). Proceeds therefore are $2,800.77. his CAGR was 3.72%



Scenario B - 5% Inflation:

Roth Investor has $3,869.68 for a CAGR of 5.41%
Traditional nets $3868.14 for a CAGR of 5.4%


Scenario C - 10%


Roth Investor has $9,646.29 for a CAGR of 10.33%
T-IRA investor nets $8,937, for a CAGR of 9.91%



Thus:

3% inf: T-IRA outperforms Roth, both outperform inflation

5% inf: Outcomes about the same, both outperform inflation

10% inf: Roth out performs inflation, Traditional lags.



Please if anyone can find any problem with my math, let me know (a distinct possibility at 5am!)

 

[bamsphd]

Lets take a concrete example.

Two investors, both in 35% tax bracket now and in 20 years.

Roth Investor - puts 1000 in a Roth IRA, pays 350 in taxes.

T-IRA Investor - puts the 1350 in a traditional IRA (assume pre-tax money)

First off, if you start with $1,350 and take away a 35% tax, you will have $1350 - $472.50 = $877.50. So your Roth initial value should be $877.50 instead of $1000.

Second, a traditional pre-tax money IRA would be taxed on the WHOLE BALANCE, not just the earnings. So instead of

tax is 781.18 (.35*[3581-1350]).

You would really have tax is (.35*$3581) = $1253.35.

There may be additional problems, but that is as far as I took it.

Please if anyone can find any problem with my math, let me know (a distinct possibility at 5am!)

Let this be a lesson, never invest at 5am!

 

[Alan]

Scenario C - 10%


Roth Investor has $9,646.29 for a CAGR of 10.33%
T-IRA investor nets $8,937, for a CAGR of 9.91%

Even if we had 10% inflation over the next 20 years and the tax rates stay the same and your math is correct the difference is so small that I wouldn't sweat it. I would use TIPS inside a Roth rather than tradional IRA simply because I believe tax rates will more likely be higher in 20 years than the differences in returns, so pay uncle Sam now. Plus Roths have various other advantages.

 

[dwshelf]

Even if we had 10% inflation over the next 20 years and the tax rates stay the same and your math is correct the difference is so small that I wouldn't sweat it. I would use TIPS inside a Roth rather than tradional IRA simply because I believe tax rates will more likely be higher in 20 years than the differences in returns, so pay uncle Sam now. Plus Roths have various other advantages.

For the same reason you can't be confident about tax rates twenty years from now, you also can't be confident that Roth income will be tax free.

Same reason you can't depend on SS.

"It's time to end the freeloading by wealthy Americans who pay no taxes and only consume".

And we meet alt-min from hell, which taxes SS, Roth IRAs, long term capital gains, whatever.

So along with the threat of inflation, one must consider the threat of adverse tax law changes.

 

[bamsphd]

I thought of a nicer way to express the math.

Suppose a 35% tax rate, or equivalently you get to keep 0.65 times the amount of money.

Suppose you are going to invest until you double your money. So the initial investment is times 2.

Let X be the amount of money you are investing.

Then a traditional IRA is equal to ((X * 2) * 0.65).

While a Roth IRA is equal to ((0.65 * X) * 2).

 

[Independent]

Alec - thanks for the spreadsheets, very useful.


Re Traditional vs Roth - I admit I was a bit myopic in my comment and was referring to my own case where traditional IRA is not pre-tax money. Therefore the difference is huge.


Having said that, I still see a difference between traditional and roth.

Lets take a concrete example.

Two investors, both in 35% tax bracket now and in 20 years.

Roth Investor - puts 1000 in a Roth IRA, pays 350 in taxes.

T-IRA Investor - puts the 1350 in a traditional IRA (assume pre-tax money)

Both buy 20 yr TIPS.

(two simplifying assumptions that should not effect illustrative nature of the below - inflation stays constant and coupons are reinvested at same rate)

Three scenarios - inflation at 3%, 5%, and 10%

Scenario A - 3% inflation

Roth Investor has $2,653.30 after 20 years (1000*[1+.02+.03]^20 )

His initial investment was 1350, so his CAGR is 3.44% (exp{ln[(2653/1350)/20}-1)


T-IRA investor has $3,581.95 after 20 years, pre tax. tax is 781.18 (.35*[3581-1350]). Proceeds therefore are $2,800.77. his CAGR was 3.72%
..........................

Please if anyone can find any problem with my math, let me know (a distinct possibility at 5am!)

Sorry for the slow response, but it looks like bamspd has already covered it. If you start with $1,350 pre-tax, your 3% scenario will result in $2,328 after tax in 20 years either way.

For the Roth, taxes take the $1,350 down to $878, then investment returns grow that to $2,328.

For the Traditional, investment returns take the $1,350 up to $3,582, then taxes shrink the $3,582 to $2,328.