In a taxable account, investing in a TIPS mutual fund or ETF has two advantages over investing in a basket of individual TIPS bonds: cash flow and the ease of tax reporting . A TIPS fund pays out both the interest earned and the inflation adjustment. The fund's shareholders report these distributions as taxable interest in the same way as they do for any other bond fund.

These distributions are called "dividends" but they have nothing to do with stock dividends and they don't qualify for favorable tax treatment on "qualified dividends." Dividends from a TIPS fund or ETF are taxed as interest income for federal income tax. Because they are paid by the U.S. Treasury, the interest income is exempt from state and local income taxes.

If an investor owns individual bonds, the inflation adjustments in those TIPS bonds are not paid out until the bonds mature. In a TIPS mutual fund or ETF, because the inflation adjustments are taxable, the fund must pay them out to the shareholders. If the Treasury does not pay out the inflation adjustments to the TIPS fund, where does the fund get the money to pay the inflation adjustments to the fund's shareholders?

The money can come from several sources. First not all the distributions are really paid out. Many investors automatically reinvest distributions. For the fund, the distributions go out and come back on paper. The actual cash doesn't leave the fund. The interest payments the fund received from the bonds may very well be enough to pay the shareholders who don't automatically reinvest distributions.

Second, there are incoming purchases from investors. Instead of using 100% of the new money to buy more bonds, the fund can save a small percentage aside for the expected distributions.

Then there are matured bonds. The fund doesn't have to invest 100% of the proceeds into new bonds. If it needs money for distributions, it can withhold some money for that purpose and reinvest the rest.

Finally there are sales proceeds. During the normal operation of the fund, the fund buys and sells bonds. If the fund estimates that it needs money for distributions, it can sell some bonds or just set aside some money from the sales proceeds like they do to incoming purchase and matured bonds.

How the fund comes up with the money for distributions isn't very important. A TIPS fund or ETF investor only needs to know that in a taxable account, there will be distributions for all taxable income and that the fund or ETF makes it easier to report and pay taxes.