Does taxation of Treasury Inflation Protected Securities (TIPS) undermine their function as protection against inflation?

Question

From this document from Vanguard:

TIPS are taxed in a slightly different manner than conventional Treasury bonds. The periodic inflation-based “gross-up” in the principal of TIPS is taxed at the ordinary income tax rate, rather than at the lower capital gains rate. These taxes are payable every tax year regardless of the investor’s holding period. If the sale price of a TIPS bond exceeds the inflation-adjusted principal, ordinary capital gains tax rates are applied. As with conventional Treasuries, the inflation-adjusted TIPS coupon payments are taxed at ordinary income tax rates.

Hypothetically let's suppose inflation jumps up to 100% next year and my current marginal tax rate is 40%. If I keep X dollars in cash, next year I'll have X/2 in today's money. If I keep the same amount in TIPS, then I'll have, again in today's money, (1/2)(X+0.6X)=(4/5)X.

In other words, inflation will still destroy a certain portion of my funds -- even if I keep them in TIPS. Is this understanding correct?

Answer 1

If the TIPS are held in a taxable account, yes. However, if the TIPS are held in a tax-advantaged account such as an IRA, then the taxation may be different as a Roth IRA may not have any gains taxed as something to consider here.