An inflation-linked bond pays you in two ways. The coupon arrives as cash. The inflation adjustment is added to the principal and arrives at maturity, possibly thirty years later. The United States taxes both in the year they accrue. So a ladder built to fund your retirement generates a tax bill on money you will not touch for decades, and at current pricing that bill consumes roughly half of the cash the bond actually pays.
Two Payments, One of Which Is Not a Payment
A Treasury Inflation-Protected Security has a fixed real coupon rate and a principal that moves with the Consumer Price Index. If prices rise 2.5% over a year, the principal rises 2.5% with them, and the coupon is then paid on the larger number.
Only one of those is money you can spend. The coupon lands in the account. The uplift does not. It sits inside the bond and is returned at maturity along with everything else.
The tax code does not make that distinction. Under the rules for inflation-indexed debt instruments the annual principal adjustment is treated as original issue discount and taxed as ordinary income in the year it accrues. The holder owes tax in the year the adjustment happens, on an amount they will not receive until the bond matures.
This is usually called phantom income, and the name is fair. The income is real for tax purposes and imaginary for spending purposes.
The Size of It
Price a rung at the real yield this site has quoted throughout, 2.37% as at July 2026, and assume inflation runs at 2.5%. Take $1,000,000 of face so the figures are legible.
In the first year the bond pays a cash coupon of about $24,000. It also accrues an inflation adjustment of about $25,000. Taxable income is roughly $49,000, of which half arrived in the account and half did not.
At a 24% federal marginal rate the tax is around $12,000, set against the $24,000 the bond actually paid. The bill has taken 48.7% of the cash.
The ratio does not improve with time, because the coupon and the adjustment both scale with the same inflated principal:
| Year | Cash coupon | Phantom accrual | Taxable | Tax at 24% | Tax as share of cash |
|---|---|---|---|---|---|
| 1 | $24,000 | $25,000 | $49,000 | $12,000 | 48.7% |
| 10 | $30,000 | $31,000 | $62,000 | $15,000 | 48.7% |
| 30 | $50,000 | $51,000 | $101,000 | $24,000 | 48.7% |
That invariance is not a coincidence of the numbers chosen. Whenever inflation runs at roughly the real yield, the phantom half of the income is roughly equal to the cash half, and tax on the whole eats about half the part you can spend. Higher inflation makes it worse rather than better, which is the uncomfortable feature. The instrument bought to protect against inflation is taxed hardest in exactly the years it is doing its job.
It Is a Timing Cost, Not a Permanent One
The obvious objection is correct. You are not taxed twice. Every adjustment you pay tax on raises your cost basis, so the principal returned at maturity comes back without a second bill.
Over the thirty years of the rung above, the accruals total roughly $1,098,000 and the tax on them roughly $263,000. All of it would have been payable eventually. What changes is when.
Discounted at a nominal rate consistent with the same assumptions, paying as you accrue costs about $125,000 in present value. Paying the identical amount at maturity would cost about $62,000. The timing alone is worth around $63,000 per $1,000,000 of face, a little over 6% of the position, and it buys nothing.
The larger problem is not the present value. It is the cash flow. The bill has to be paid from somewhere, and by construction it cannot be paid from the money it is levied on. A retiree funding their living from a ladder must find the tax out of the coupon, out of another asset, or out of the very portfolio the ladder was built to make unnecessary to sell. That last option reintroduces the exact behaviour an earlier post in this series argued the ladder exists to avoid.
The Wrapper Decision Pulls Two Ways
The standard answer is to hold inflation-linked bonds inside a tax-deferred account, where accruals are invisible until withdrawal and the phantom problem disappears.
That answer is right more often than not, but it is not free, because Treasury obligations carry a second feature the tax-deferred account throws away. Interest on federal debt is exempt from state and local income tax. Move the bonds into a deferred wrapper and the exemption is worth nothing, since the eventual withdrawal is taxed as ordinary income by the state like anything else.
So the decision turns on where you live, and it genuinely reverses.
In a state with no income tax the exemption is worth nothing to begin with, so there is nothing to lose. Hold the bonds in the tax-deferred account and the phantom income problem is solved outright.
In a high-tax state the exemption is a real annual saving weighed against a real annual cost. Neither dominates. The answer depends on the state rate, the federal marginal rate, and how long the ladder runs.
This is one of the few places in retirement planning where the location decision is worth more than the selection decision. Which bonds you buy matters less than which account they sit in.
A Structural Answer
There is a third option that removes the problem rather than relocating it.
Defined-maturity inflation-linked funds hold a rung's worth of bonds maturing in a single year and terminate on that date. Because they are funds, they distribute what they earn, and that includes the inflation adjustment. The accrual leaves the fund as cash in the year it is taxed.
Allan Roth, an hourly-fee financial planner who has written extensively on ladder construction, described the effect on Larry Kotlikoff's Economics Matters podcast: the structure hands back both the coupon and the CPI adjustment, so the phantom income issue does not arise. It also simplifies building a rung, since sizing collapses to the target divided by one plus the yield, compounded to maturity, rather than a hand-built calculation across coupons and an inflating principal.
The cost is a management fee, in the region of ten basis points. Whether that is a good trade depends on the same variables as the wrapper decision. For a rung held in a taxable account in a high-tax state, a fee measured in basis points against a timing cost measured in whole percentage points is not a close call. Inside a tax-deferred account, where the phantom problem does not exist, the fee is pure cost and individual bonds win.
What the Calculator Does and Does Not Model
This site's funded ratio can be computed pre-tax or after-tax, and the after-tax path applies a haircut by account wrapper. It does not model phantom income.
That is a real limitation and worth naming precisely rather than waving at. For a ladder held in a tax-deferred account the omission changes nothing, because there is nothing to model. For a ladder held in a taxable account the after-tax figure is optimistic, and it is optimistic by more in higher-inflation scenarios.
The direction of the error is knowable even where the size is not. If your holdings are taxable and inflation-linked, treat the after-tax number as an upper bound.
What This Does Not Say
This describes the United States. The instrument exists elsewhere under other names and other tax treatments, and none of the above transfers. A reader outside the US should take nothing from it except the general lesson that the shape of a bond's cash flows and the shape of its tax bill are two different things, worth checking separately.
Nor does any of it argue against inflation-linked bonds. The phantom income problem is a feature of holding them in the wrong container, and it has at least two clean solutions. A ladder remains the only instrument that funds a real liability with a matched real asset, which is the entire argument of this series.
It is also not tax advice. The wrapper decision in particular depends on facts about you that this site does not know and does not ask for.
The narrow claim is this. A plan that prices a ladder pre-tax and then assumes the after-tax result is a modest haircut has missed something structural. The tax does not arrive in proportion to the cash. It arrives ahead of it.
A ladder converts a portfolio you have to sell into an income you receive, and that is most of the argument for building one. The tax code interrupts the story once, by taxing the half of the income that has not arrived yet. It is a solvable problem, and the solutions are the account you hold it in and the wrapper you hold it through, neither of which feels like it should matter this much.
The bond pays you twice and the second payment is thirty years late. The tax is not.
This is Post 15 of The Funded Ratio — a series on amifunded.com applying actuarial principles to individual retirement portfolios. Built on the US Treasury regulations for inflation-indexed debt instruments (original issue discount treatment), 31 U.S.C. §3124 on the state and local tax exemption for federal obligations, and Allan Roth's discussion of ladder construction and defined-maturity inflation-linked funds on Larry Kotlikoff's Economics Matters podcast (2026). No financial advice is given. All methods use publicly available academic research and market data.