Inflation and taxes and your investments

by Cort Wilcox
| June 27, 2010 9:00 PM

Fear has embraced many individual investors after witnessing one of the worst bear markets in 2008, followed by an inspiring year end for 2009, only to be plagued again with a dizzying, volatile, headline-driven market so far through 2010. Some investors have retreated to cash, short-term Treasuries, or CDs as a respite from their fear of investing. It's not a bad strategy for the short-term nervous Nelly. But fear for some is persistent. As far back as I can remember, even in childhood, there was always a reason to believe the country and world were about to fall apart. You probably recall, as I do, hearing your parents and grandparents talk about how the country was falling apart. Things haven't changed, and continuous fear of taking a risk of losing money ultimately becomes a self-fulfilling prophecy. Often people in constant fear of losing any money put themselves in a position where they can only lose the value of their money. The enemies for that position are inflation and taxes.

Most everyone has some understanding of how inflation affects the purchasing power of our money.

As an example, let's say you purchased a candy bar one year ago for $1.00, and today the same candy bar costs $2.00. Your purchasing power of your dollar dropped by 50 percent. This simple example of the change in the price of a candy bar only represents one good example, but inflation, properly defined, is a rise in the general price level of goods and services. In recent decades, inflation has occurred in two predominate forms. In the '70s and early '80s there was a steep increase in prices and double-digit inflation. The second form of inflation, and the most common, is a long and persistent rise in prices that slowly erodes purchasing power like we are experiencing now.

There is another significant element in losing purchasing power, which is in the form of taxes. The following is an example of how inflation and taxes affect investors' purchasing power. This is critical for investors to understand. Let's assume inflation is at an annual rate of 3 percent. An investor, looking to preserve his or her purchasing power, purchases a one-year certificate of deposit for $1,000 on Jan. 1, paying 3 percent interest. On Dec. 31 that investor gets the $1,000 back. Inflation has reduced the purchasing power of the original investment down 3 percent to $970, but the $30 in interest earned brings his purchasing power back to even. But now the investor has to pay ordinary income tax on the $30. Assuming a 25 percent federal tax and 8 percent state tax, the investor will only net $20.70 in interest income. As a result, the investor lost approximately 1 percent purchasing power, with a 3 percent investment, in a period of 3 percent inflation. The investor has the illusion that he has protected himself from loss, but actually suffered a predictable loss in the real value of his money.

Let's carry this out with one more example. Let's assume this investor recognizes that he needs to get 4 percent just to break even in a 3 percent inflationary environment. He finds that he has to purchase a five-year CD to achieve a 4 percent yield. He purchases the CD but during his five years of ownership, inflation creeps up to 4 percent or higher. You don't need to do the math to recognize he still lost purchasing power of his original CD investment.

For investors who have plenty of assets to live out their lives with consideration of taxes and inflation eroding their assets, a laddered CD portfolio is one of several appropriate investment tactics. But the majority of us need to not only maintain our purchasing power after inflation and taxes, but need our investments to perform better to meet retirement or other financial goals. To do this we need to use a broad base of investments such as stocks, bonds, real estate and cash. This means there is a higher level of volatility, but the risk can be mitigated with diversification of assets. Proper allocation of a diversified portfolio can be complicated, but necessary to properly align your assets to your objectives and your acceptable risk tolerance in order to beat inflation and taxes, while increasing purchasing power.

Cort Wilcox

D.A. Davidson & Co.

Financial Consultant, Vice President

667-1212 cwilcox@dadco.com