TIPS are bonds. Like interest from other bonds, interest paid from TIPS is taxed as ordinary income. The inflation adjustment to TIPS principal is also taxed as ordinary income. Taxes on TIPS can be complicated but there are easy ways out.
The easiest way to handle taxes on TIPS is by putting them in a tax deferred or tax free (Roth) account. Then you don’t have to worry about it. There is no tax while they are in a tax deferred or tax free account. When you withdraw, you pay ordinary income tax on the withdrawal. It doesn’t matter whether the distribution comes from TIPS, regular bonds, or stocks.
If you’d like to buy TIPS in a taxable account, another easy way to handle taxes is by buying them through a mutual fund or ETF. The mutual fund or ETF will distribute taxable income and capital gains to you. You pay taxes as you normally do for any other mutual fund or ETF. Because TIPS are Treasury bonds, the interest income is taxed as ordinary income for federal income tax but it is exempt from state and local income taxes.
Taxes get much more complicated if you buy individual TIPS in a taxable account. You must calculate income for each and every individual bond. The interest paid to you during the year is taxed as ordinary income. The inflation adjustment to TIPS principal is also taxed as ordinary income, although it’s not paid until the bond matures.
The difference between the the price you paid and the bond’s face value must also be tracked and amortized over the life of the bond. These are called Original Issue Discount (OID) and Bond Premium Amortization (BPA). If there is deflation, not inflation in one year, you get to deduct against some income you declared in the previous years. If there is not enough, you carry forward the deduction. Suffice it to say, it gets much more complicated.