Everybody loves the safety of Treasury securities. Everybody from a high-tax state loves the fact that they are local-income-tax exempt, and everybody has to be tempted at the notion of a bond that protects you from inflation, as the soon-to-be-issued inflation-indexed Treasuries will do.

But everyone should be careful, because what’s not commonly understood is the way these bonds are taxed. If you buy them at all, you would want to buy them under the umbrella of a tax-sheltered IRA, Keogh or similar account.

Here’s how it works. Say you buy $10,000 of these bonds and that, when they finally come to market, the “real” interest rate turns out to be 3%. You will get a check for $300 (actually, two semiannual $150 checks, I think). But say inflation the first year is 10%. It won’t be, but this makes the example easy to follow.

The Treasury will acknowledge this by adjusting the principal value of your bonds upward, from $10,000 to $11,000 in this example. (What the market would pay you for the bonds if you chose to sell them in the meantime is another story.) If there were no more inflation from then on, until they matured, you’d get $11,000 at maturity.

The only problem — and it’s a big one — is that this extra $1,000 is taxed as ordinary income, and treated as if you received it this year! You would be expected to pay ordinary income tax on both the $300 interest you received plus the $1,000 you didn’t.

To someone in the 36% federal tax bracket, that would be $360 in tax on the way-off-in-the-distance $1,000 inflation adjustment. So you would have gotten $300 in cash from Uncle Sam and would then have to turn around and pay him $468 — 36% of your $300 interest and $1,000 inflation adjustment.

An interesting form of forced saving, I suppose.

As a patriot, I hope a lot of people buy these bonds. As your financial advisor, I’d suggest you think twice.

Even as part of a retirement plan, you might think twice. The local-tax-free aspect of Treasuries would be wasted, since there’d be no tax at all to pay until withdrawal, at which point withdrawals would be subject to local income taxes. What’s more, while I do think the U.S. stock market is awfully high here, I don’t think Treasuries — even inflation adjusted — are likely to do as well over the long haul as equity investments here and abroad. They’re safer — but you’re paying for that safety.

(Speaking of the Treasury and taxes, don’t forget: Tomorrow is the deadline to send in fourth quarter estimated-tax payments. This applies to you if, through employer withholding plus any prior estimated tax payments, you haven’t yet paid Uncle Sam at least 90% of the 1996 tax that will be due April 15. Exceptions: if the amount you’ve thus far paid Uncle Sam for 1996 equals 100% of your 1995 tax bill — 110% if 1995 adjusted gross income exceeded $150,000 — you’re excused from paying additional estimated tax for 1996.)

Tomorrow: Yahoo for Yahoo!

 

 

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