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The Second Evil Twin: Taxes

Watch out for inflation and taxes when trying to build wealth.

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%.

And this example does not take state tax into account. If state income tax were also subtracted, the amount would be reduced even more.

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.

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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 table I've posted at the end of the transcript for this episode at

Quickanddirtytips.com. (For more calculators,

click here.)

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 constitution, which was ratified in 1913 (the same year 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 deemed unconstitutional and were relatively short-lived.

For those of you who want to learn more, I've also posted a link here and at the end of the transcript to

a brief history of the U.S. tax system. To check out this additional information, visit the Money Girl Web site at

Quickanddirtytips.com.

As always, everyone's situation is different, so be sure to consult a tax or financial adviser 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.

Related links:

History of the U.S. Tax System

The 16th Amendment of the U.S. Constitution

Elizabeth Carlassare is the creator of the

Money Girl podcast. A business and technology writer, investor, and former mortgage loan officer, she has a long-standing passion for helping people make the most of their money. She is the author of the Internet business book, "Dotcom Divas," and has been interviewed on more than 60 regional and national radio programs, and featured on C-SPAN Book TV. Elizabeth holds an M.S. from the University of California, Berkeley. She has spoken internationally on the topic of women's entrepreneurship and access to capital. To request a topic or share a money tip, send an email to money@qdnow.com or call 877-6-RICHER.