An investor purchases a newly issued 10-year Treasury Inflation-Protected Security (TIPS) … — FINRA SIE (Securities Industry Essentials)

An investor purchases a newly issued 10-year Treasury Inflation-Protected Security (TIPS) with a par value of $1,000$ dollars and a $3\%$ nominal annual coupon rate. If the Consumer Price Index (CPI) increases by $4\%$ during the security's first year, which of the following accurately describes the adjustment to the bond's principal, the annual interest payout, and the federal income tax implications for that year?

The principal value increases to $1,040, the annual interest payment increases to$ 31.20, and the $40 principal inflation adjustment is taxable as federal ordinary income in the year it occurs.Answer
B
The principal value remains fixed at $1,000, the annual interest payment increases to$ 70 to account for inflation, and only the interest received is subject to federal income tax.
C
The principal value increases to $1,040, the annual interest payment remains fixed at$ 30, and taxes on the $40 principal adjustment are deferred until the security matures or is sold.
D
The principal value increases to $1,040, the annual interest payment increases to$ 31.20, and both the interest income and the principal adjustment are completely exempt from federal income taxation.

Answer

The principal value increases to

1,040, the annual interest payment increases to

31.20, and the $40 principal inflation adjustment is taxable as federal ordinary income in the year it occurs.

Treasury Inflation-Protected Securities (TIPS) are designed to protect investors from purchasing power risk by adjusting their principal value based on changes in the Consumer Price Index (CPI). With a

4\%

CPI increase, the

1,000 principal adjusts upward by

4\%

to

1,040. The fixed

3\%

annual coupon rate is applied to this new principal value, resulting in an annual interest payout of

31.20 (

1,040 \times 3\%

). For federal tax purposes, both the interest payment and the

40 principal inflation adjustment ('phantom income') are taxable as federal ordinary income in the year they occur.

Step-by-Step Solution

Calculate the inflation-adjusted principal value at the end of the year.

Initial principal of

1,000 multiplied by

(1 + 0.04) = $1,040.

TIPS principal values adjust directly in proportion to changes in the Consumer Price Index (CPI).

Calculate the annual coupon interest payment based on the adjusted principal.

The fixed

3\%

coupon rate applied to the

1,040 principal yields

1,040 \times 0.03 = $31.20.

The fixed coupon rate is paid on the newly adjusted principal amount rather than the original par value.

Determine the federal tax treatment of the interest income and principal growth.

Both the

31.20 interest income and the

40 annual principal adjustment ('phantom income') are subject to federal ordinary income tax in the year accrued.

Federal tax law requires investors to pay federal income tax annually on both coupon payments and TIPS inflation-adjusted principal increases.

Key Concept

Treasury Inflation-Protected Securities (TIPS) principal adjustments, interest calculations, and federal income tax treatment

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