Thursday, August 4, 2005

Keep Pace with Taxes and Inflation

Hello and welcome to Money Girl’s Quick and Dirty Tips for a Richer Life.

Today’s Topic: Taxes.

Inflation and taxes are two very sinister foes when it comes to creating wealth. I think of them as the evil twins. Last week, I talked about the first evil twin: inflation. This week, I want to focus on the second evil twin. You got it: taxes. To get ahead, your money needs to earn a rate of return that outstrips the effects of both taxes and inflation.

Let’s take an example (which is a variation on the example from last week’s episode). Let’s say you save $2,000 a year and put it in a savings account earning 3% a year and let’s say you do this for 30 years. After that 30 years, you’d have $60,000 plus interest of $38,005 for a total amount of $98,005.

Nope. You certainly wouldn’t. First, you would need to pay income tax on the interest you earned. Let’s say you’re in the 25% tax bracket. The $38,005 you earned in interest would be reduced by $11,716. So your savings plus interest after taxes would be $86,289, not $98,005.

Plus this example doesn't take state tax into account. Depending on you state's tax rate, the amount could be reduced even more.

But the story doesn't end there. Inflation takes its toll too. In the U.S., inflation has averaged 4.2% per year over the last 30 years. At this inflation rate, your after-tax savings of $86,289 would be further reduced by nearly half. Your savings plus interest after both taxes and inflation would be $44,862 real dollars after 30 years, not the $98,005 you’d have without taxes and inflation. Now that's a huge difference!

In total, taxes and inflation reduce your $98,005 in savings plus interest by more than half over the 30 years! The effective yearly rate you earn is the 3% interest minus 0.75% for taxes minus the 4.2% inflation rate, which is a negative 1.95%.

Calculate the Rate You Must Earn to Keep Pace with Taxes and Inflation: