The U.S. tax code is famously complicated.
Congress, over decades, has enacted tax measures (and will continue to do so) that it believes will benefit society (or at least segments of society that they care more about than others, a.k.a., earmarking or pork).
One aspect that bewilders me is that we’re required to calculate as income interest and capital gains in nominal dollars, which means that you have to pay income taxes when you don’t really make money.
Different Income Scenarios
Here are three scenarios and the “income” you'd be taxed on in each if it wasn’t in a tax-free or tax-deferred account. For each of these, let’s assume two cases, one with inflation running at about 2% as it has for years now, and one where it spikes to 10% which is about where it was in the early 70s.
For simplicity, let’s assume your tax bracket is 15% for capital gains and 22% for interest.
On January 2, you put $10,000 in a savings account earning 1% interest and let it sit there for a year.
You own $10,000 worth of shares in a stock that pays a 3% annual dividend.
Capital Gains Income
You buy $10,000 worth of shares in a stock on January 2 and sell it after a year and a day.
How Things Play Out Depends on Inflation
If inflation is running at 2% a year, as it has for many years now, here’s what you can expect.
If inflation would hit 10% a year like it did in the early 70s, here’s what you can expect. Savings accounts pay higher interest, and stock share prices may grow faster.
Looking at these two tables, here are the lessons we should learn. Let’s start with things that are true in general.
- In general, cash and its equivalents are a bad long-term “investment” because after taxes and inflation, you’ll likely be losing money each year.
- Stock dividends can be a good investment option if these stocks also experience share price appreciation. If they don’t, they’re not a great investment in a taxable account.
- Over the long term, allocating a significant part of your portfolio in stocks is a crucial part of building wealth.
Next, let’s look at what we can learn by comparing the results in the two tables.
- When inflation is high, your after-tax, inflation-adjusted results are somewhat worse for cash equivalents and much worse for stock dividends (since these don’t usually go up with inflation).
- When inflation is high, the fact that we’re taxed on nominal rather than real inflation-adjusted returns means that a significant part of our returns goes away. Comparing the two cases above, a full 25% of your real after-tax returns go away because of taxes on phantom “gains” that inflation eats up. Indeed, if only real capital gains were taxed, the final result for the 10%-inflation case would be 6.2%, almost the same as the 6.4% in the 2%-inflation case.
The final, most general lesson is that our tax code means that the benefit of placing your retirement portfolio in a tax-deferred rather than taxable account becomes even more important when inflation runs high.
The Bottom Line
Not too many people realize how inflation affects us far beyond the higher prices we pay for things we buy. The above shows how it even affects our taxes, and makes us pay for phantom income that doesn't increase our purchasing power.
Financial strategy is all about setting financial goals, crafting a plan to reach them, and doing what's needed to start implementing that plan in both your business and personal life. Doing all this over years and decades requires you to consider factors that most people aren't aware of. If you'd like to learn what financial strategy can help you accomplish, email me and we'll coordinate a free, no-strings-attached phone call to explore that.
This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.