What this article covers
Because the U.S. tax code taxes interest and capital gains in nominal dollars, inflation can leave you owing tax on “gains” that never raised your purchasing power. Opher Ganel compares the after-tax, inflation-adjusted results of a savings account, a dividend stock and a stock sold for a long-term gain at 2% and 10% inflation, and shows why high inflation makes tax-deferred retirement accounts even more valuable.
Key Takeaways
You pay tax on investment gains that inflation has already erased
The U.S. tax code calculates interest and capital gains in nominal dollars, not inflation-adjusted ones, so part of what you are taxed on is a phantom gain that only keeps pace with rising prices. Opher Ganel’s comparison assumes a 22% rate on interest and 15% on capital gains for $10,000 held for a year in a taxable account.
High inflation can wipe out about a quarter of your real after-tax returns
Comparing a 2%-inflation and a 10%-inflation environment, a full 25% of real after-tax returns disappear because of taxes on phantom gains. If only real capital gains were taxed, the 10%-inflation result would be 6.2%, almost the same as the 6.4% in the 2%-inflation case.
Cash and dividend stocks without price growth fare worst in a taxable account
After taxes and inflation, cash and its equivalents will likely lose money each year, and high inflation hurts stock dividends most because they don’t usually rise with inflation. Opher concludes that a significant stock allocation is crucial to building wealth, and that holding your retirement portfolio in a tax-deferred account matters even more when inflation runs high.
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.
Three Kinds of Investment Income: Interest, Dividends and Capital Gains
Here are three scenarios and the “income” it would be taxed on 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 2% as it has for many 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.
Interest Income: $10,000 in a Savings Account
On January 2, you put $10,000 in a savings account earning and let it sit there for a year.
Dividend Income: $10,000 in a Stock Paying a 3% Dividend
You own $10,000 worth of shares in a stock that pays a 3% dividend.
Capital Gains Income: Selling a Stock After More Than a Year
You buy $10,000 worth of shares in a stock on January 2 and sell it after a year and a day.
After-Tax Real Returns at 2% vs. 10% Inflation
If inflation is running at 2% a year, as it has for many years now, here’s what you can expect.
If inflation is running at 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.
What Inflation and Taxes Mean for Your Taxable Portfolio
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.
Frequently Asked Questions
Do you pay taxes on investment gains caused by inflation?
Yes. The U.S. tax code requires you to calculate interest and capital gains in nominal dollars, so you owe tax on the full increase even when part of it only reflects inflation. Opher Ganel calls these taxes on phantom gains, and they mean you can pay income tax when you don’t really make money.
How does high inflation affect after-tax investment returns?
In the article’s comparison, results at 10% inflation are somewhat worse for cash equivalents and much worse for stock dividends than at 2% inflation. Overall, a full 25% of real after-tax returns go away because of taxes on gains that inflation eats up.
Is a savings account a good long-term investment?
Not in a taxable account, according to the article. After taxes and inflation, cash and its equivalents will likely lose money each year, so they work poorly as a long-term investment.
Are dividend stocks a good investment in a taxable account?
Only if the stocks also experience share price appreciation. Dividends don’t usually go up with inflation, so when inflation is high, the after-tax, inflation-adjusted result for dividend income is much worse.
Why does a tax-deferred account matter more when inflation is high?
Investment income held outside a tax-free or tax-deferred account is taxed in nominal dollars, and the higher inflation runs, the more of that tax falls on phantom gains. That’s why Opher concludes that placing your retirement portfolio in a tax-deferred rather than taxable account becomes even more important when inflation runs high.
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Disclaimer: 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.
About the author
Contributing Writer, Wealthtender
My career has taken some unexpected turns, from earning a PhD in experimental high-energy physics, to conducting cosmic-ray research in Antarctica, to supporting NASA projects and programs, to running my own consulting business. I also run several other small businesses and help my wife run her Marriage and Family Therapy practice.
Those experiences taught me to question assumptions, think critically, and recognize that real-world decisions of any significance rarely have simple answers that apply to everyone. Today, I bring that perspective to writing about personal finance. Drawing on my analytical background, business experience, and research, I explore financial decisions, challenge conventional wisdom, and help readers understand the tradeoffs that can affect their financial well-being. To complement my own research and experience, I also weave insights from financial professionals into my articles, drawing on their expertise and real-world experience helping clients navigate financial decisions and challenges.
At medium.com/@opher-ganel, you can read more of my articles and subscribe to receive email notifications when new ones come out.