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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.
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.
You buy $10,000 worth of shares in a stock on January 2 and sell it after a year and a day.
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.
Next, let’s look at what we can learn by comparing the results in the two tables.
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.
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.