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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” 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.
On January 2, you put $10,000 in a savings account earning and let it sit there for a year.
You own $10,000 worth of shares in a stock that pays a 3% 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 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.
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.
About the Author
My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.