Bond premium amortization can also be an issue if you own individual TIPS in a taxable account. It's not an issue if you own individual TIPS in a tax deferred or tax free account. It's also not an issue if you own TIPS mutual funds or ETFs in a taxable account.

Bond premium amortization arises when you buy a bond with a coupon rate above the market yield. The bond pays more interest than you actually earn. The excess is basically a return of the premium you paid. If you amortize the premium, you can reduce the taxes you owe on the interest.

The IRS publishes rules on bond premium amortization in Publication 550 Investment Income and Expenses and in regulation 26 CFR 1.171-2. I must admit these are difficult to read or understand. Let me try to illustrate it with a real world example.

Facts

Suppose you purchased ten 20-year TIPS (CUSIP 912810FR4) at auction on Jan. 25, 2005. The interest rate was 2.375%. The yield was 2.000%. You paid 107.552 as the adjusted price plus $1.06364 per bond as the adjusted accrued interest on Jan. 31, 2005 (the issue date). The index ratio for this TIPS bond was 1.01326 on the issue date. These numbers are on the auction result announcement.

Calculation

The first rule about bond premium amortization is you don't have to do it. If you choose not to amortize, you treat the premium as a capital loss when you sell or when the bond matures. This is the simplest way to deal with it.

You paid a premium of

$1,000 * (107.552 / 100 - 1.01326) * 10 = $622.60

in 2005. When the bonds mature in 2025, you realize a capital loss of $622.60. If you sell the bonds before they mature, say at an unadjusted price of 103, your capital loss is

$1,000 * (107.552 / 100 - 103 /100 * 1.01326) * 10 = $271.37

However, it is to your advantage to amortize the premium throughout the life of the bond. This way you pay lower taxes sooner. You use a portion of the premium to reduce the interest income you must report every year.

For TIPS, the bond premium amortization is done as if there is no more inflation or deflation after you purchase the bond.

If there isn't any inflation or deflation after Jan. 31, 2005, the ten TIPS bonds in our example would pay interest twice a year in the amount of:

$1,000 * 1.01326 * 2.375% / 2 * 10 = $120.32

The first interest payment date is July 15, 2005. There are 181 days between the dated date Jan. 15, 2005 and July 15, 2005. There are 165 days between Jan. 31, 2005 (the issue date) and July 15, 2005. Under the constant yield method, the bonds would pay interest on July 15, 2005:

$1,000 * 1.07552 * 2.000% / 2 * 165 / 181 * 10 = $98.04

The bond premium amortization on the first interest payment date would be:

$120.32 - $1.06364 * 10 (accrued interest) - $98.04 = $11.64

Your basis after the bond premium amortization on July 15, 2005 became:

$1,000 * 1.07552 - $11.64 = $10,743.56

On the next interest payment date, Jan. 15, 2006, under the constant yield method, the ten bonds would pay interest

$10,743.56 * 2.000% / 2 = $107.44

The bond premium amortization on Jan. 15, 2006 would be:

$120.32 - $107.44 = $12.88

And your basis on Jan. 15, 2006 became:

$10,743.56 - $12.88 = $10,730.68

You keep doing this for each interest payment until you sell the bond or until the bond matures on Jan. 15, 2025. This spreadsheet shows you how to set up a bond premium amortization schedule. Because the bond premium amortization reduces your interest income, you pay less tax on the interest.

You have to decide whether doing the math on bond premium amortization is worth it. Not amortizing is simpler. Putting TIPS in a tax deferred or tax free account will make this math problem go away.