How Inflation and Taxes Impact Investments Earning Interest - dummies

How Inflation and Taxes Impact Investments Earning Interest

By Eric Tyson

Bank accounts and bonds that pay a decent return are reassuring to many investors. Earning a small amount of interest sure beats losing some or all of your money in a risky investment.

The problem is that money in a savings account, for example, that pays 3 percent isn’t actually yielding you 3 percent. It’s not that the bank is lying; it’s just that your investment bucket contains some not-so-obvious holes.

The first hole is taxes. When you earn interest, you must pay taxes on it (unless you invest the money in a retirement account, in which case you generally pay the taxes later when you withdraw the money). If you’re a moderate-income earner, you end up losing about a third of your interest to taxes. Your 3 percent return is now down to 2 percent.

But the second hole in your investment bucket can be even bigger than taxes: inflation. Although a few products become cheaper over time (computers, for example), most goods and services increase in price. Inflation in the United States has been running about 3 percent per year over the long term. Inflation depresses the purchasing power of your investments’ returns. If you subtract the 3 percent “cost” of inflation from the remaining 2 percent after payment of taxes, I’m sorry to say that you’ve lost 1 percent on your investment.

To recap: For every dollar you invested in the bank a year ago, despite the fact that the bank paid you your 3 pennies of interest, you’re left with only 99 cents in real purchasing power for every dollar you had a year ago. In other words, thanks to the inflation and tax holes in your investment bucket, you can buy less with your money now than you could have a year ago, even though you’ve invested your money for a year.