FINRA Series 7Investment Information and Suitable RecommendationsMedium
A client purchases a Treasury Inflation-Protected Security (TIPS) with a $1,000 par value and a 3% coupon. During the year, the CPI causes the principal to be adjusted upward to $1,030. How is this $30 increase in principal treated for federal tax purposes?
- AIt is exempt from federal tax like municipal bond interest
- BIt is tax-deferred until the bond matures or is sold
- CIt is taxable as ordinary income in the year the adjustment occurs, even though not received in cash
- DIt is taxed as a long-term capital gain in the year of adjustment
Show answer & explanationAnswer & explanation
Correct answer: C. It is taxable as ordinary income in the year the adjustment occurs, even though not received in cash
TIPS principal adjustments for inflation are taxed as ordinary income in the year they occur, even though the investor does not receive the additional principal in cash until maturity or sale — this is known as phantom income.
Why the other options are wrong
- A. TIPS are federal government securities and their income is taxable at the federal level.
- B. TIPS inflation adjustments are taxed annually, not deferred.
- D. The adjustment is treated as ordinary interest income, not a capital gain.
TIPS Phantom Income
The annual inflation adjustment to a TIPS bond's principal is taxed as ordinary income each year, even though the investor doesn't receive the cash until maturity.
- Principal adjusts with CPI
- Adjustment taxed annually as phantom income
- Coupon interest is also taxable federally (exempt from state/local tax)
Memory trick: 'TIPS tax the ghost of gains not yet in hand.'