Don't Let Inflation, Taxes Erode Your Savings
Stashing cash in a savings account every month is an essential step toward financial security, but it's not enough. You must also find ways to preserve and increase the purchasing power of your savings in the face of two serious threats: inflation and taxes.
Remember that some of the interest you earn on a savings account will be siphoned off to pay taxes each year. Meanwhile, inflation will chip away at the value of what remains.
The online Savings, Taxes and Inflation
from
can help you sort out how much various rates of inflation and taxation will affect the value of your savings over time.
The calculator works by figuring out the value your yearly account balances in today's dollars (that is, adjusted for inflation) based on six factors:
Initial balance
Monthly savings
Expected rate of return
Your federal tax bracket
Your state tax bracket
Expected rate of inflation
Say you have $2,000 in a savings account that pays 2% interest. You make additional monthly deposits of $200. If there were neither inflation nor taxation, you would accumulate $29,001 after 10 years -- of which $3,001 would represent your accumulated interest.
Now consider the impact of taxes on that number. If you enter marginal tax rates of 25% (federal) and 8% (state) into the calculator, you end up with an account balance of $27,970 after 10 years -- or $1,031 less.
But that balance of $27,970 is in today's dollars, and doesn't take into account the impact of inflation, which recently hit 4%, according to
.
Given a 4% inflation rate, your savings would be worth only $18,895 in today's dollars. That's a $3,105 loss in purchasing power -- a poor return on the $26,000 you would deposit over 10 years.
Ideally, you would like your savings to increase its purchasing power over time. That's particularly important with long-term savings that you are setting aside for retirement or other goals that are years in the future.
The best way to achieve such a goal is to invest in a diversified portfolio of investments that includes growth-oriented holdings such as stocks. You can reduce your tax liability by investing that money in tax-favored retirement savings accounts such as 401(k)s.
What about short-term savings that you might need to draw upon within the next year or two? You could move money from your savings account to higher-yielding instruments such as long-term bonds or long-term CDs. Trouble is, you'll then be stuck with those yields if interest rates rise sharply (unless you sell your bond for a loss or cash in your CD and pay a penalty).
Instead, you might consider putting some short-term savings into relatively liquid vehicles that yield a bit more than savings accounts. For example, six-month CDs recently paid just under 3% vs. around 1.5% for savings accounts.
As for taxes on your short-term holdings, consider tax-free municipal money market funds if you're in a high tax bracket. Average annual returns for municipal money market funds are around 3% -- that's a taxable equivalent yield of 4% for a shareholder in a federal tax bracket of 25%.
Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.