Taxes
Inflation and taxes are two very sinister foes when it comes to creating wealth.
Elizabeth Carlassare
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Taxes
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.
How Taxes and Inflation Affect Your Earnings
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 your 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%.
How to Improve Your Rate of Return
Remember, when you think about the rate of return you want to achieve with your investments, it’s the rate of return after taxes and after inflation that counts. [[AdMiddle]
So what rate would you need to earn on your money to offset the combined effect of taxes and inflation? To find out, check out the nifty calculator I’ve posted at the bottom of this page.
The History of Taxes
And here’s one more point on taxes. Did you know that we haven’t always had an income tax in the U.S.? The 16th amendment of the constitutionopens IMAGE file , which was ratified in 1913 (the same year that the Federal Reserve was created), gave Congress the power to collect taxes on personal income. Before 1913, attempts by the U.S. government to levy tax on personal incomes were relatively short-lived. And when a flat-rate Federal income tax was enacted in 1894, it was quickly deemed unconstitutional.
For those of you who want to learn more, here’s a link to a brief history of the U.S. tax system.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.
Cha-ching! That’s all for now, courtesy of Money Girl, your guide to a richer life.
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* Calculations assume annual compounding.
Calculate the Rate You Must Earn to Keep Pace with Taxes and Inflation
Related links:
· History of the U.S. Tax System
· The 16th Amendment of the U.S. Constitutionopens IMAGE file
Image courtesy of Shutterstock