Tax + Inflation = Investor Loss

Tax time is a good time to evaluate the tax-efficiency of your investment strategy. This is especially true if the market volatility of recent years has spooked you into replacing the equities in your portfolio with “safer” investments that guarantee your principal and interest.

In the Knowledge Bureau Report of April 4, I promised you a look at the eroding effects of both taxes and inflation on your investment returns. The picture is not pretty.

Recall that reporting interest on your income tax return follows two basic tax rules:

• You report interest in the tax year in which it is actually received or receivable.

• You report interest accrued from compounding investments on the debt’s anniversary date, even though you haven’t received the cash.

What effect do those rules, and the annual inflation rate, have on your real returns?  Consider the following chart, which analyzes the real return on a $1,000 Canada Savings Bond.  In this scenario, we are assuming a 1.8% interest rate, 3% annual inflation and a 10-year hold period.  The taxpayer is in the 31% tax bracket.  Amounts shown are in current-year dollars (i.e. adjusted for inflation from year 0).

After 10 years, your return after taxes and inflation is actually a loss of 14.41% in real dollar terms.  Was this a safe investment?  At the outset, you may have said “Yes” because the principle is guaranteed. Unfortunately, your principle has lost purchasing power because it could not compete with the eroding factors of annual taxes and inflation.

It’s Your Money.  Your Life.  Both time and money are precious. Always consider the real rate of return — after taxes, after inflation and after taking into account the costs associated with the investment — that you must earn to create purchasing power when you need it.  And be sure to discuss the role of interest in your overall portfolio with your advisors.

Evelyn Jacks is president of Knowledge Bureau and author of Essential Tax Facts 2012 and co-author of Financial Recovery in a Fragile World with Al Emid and Robert Ironside.  Follow her on twitter @evelynjacks

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