The Second Evil Twin: Taxes

The following is a transcript of "Money Girl's Quick and Dirty Tips for a Richer Life," a podcast from QuickAndDirtyTips.com. The audio program is available via RSS feed here and at TheStreet.com's podcast home page.

Hello and welcome to Money Girl's Quick and Dirty Tips for a Richer Life.

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.

Let's take an example (which is a variation on the example in 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 the 30 years, you'd have $60,000 plus interest of $38,005 for a total amount of $98,005. (Calculations assume annual compounding.)

Or would you?

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.

But that's not the end of the story. Inflation takes its toll, too. In the U.S., inflation has averaged 4.2% per year over the last 30 years. At that inflation rate, your after-tax savings of $86,289 would be further reduced by $41,427. 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.

So taxes and inflation reduce your $98,005 in savings plus interest by more than half over the 30 years! In this example, the effective rate you earn is the 3% interest minus 0.75% for taxes minus the 4.2% inflation rate, which is a negative 1.95%.

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