When analyzing your portfolio, there are three variables that you need to take into account: Return, Taxes, & Inflation.
Return on your investments is fairly self-explanatory. Obviously return is a function of risk assumed, all things else being considered. The problem is, return is often the only hurdle that people attempt to solve for.
Taxes & Inflation play just as import a role in determining how much earnings in your account actually show up in your pocket.
Here’s a short example of how taxes and inflation can eat away at our investment returns. Let’s assume a 5% return – a decent return for a moderately conservative investor entering retirement.
|Return after one year (5%)||+$500|
|Federal Income Taxes (25%)||– $125|
|Net After Tax Investment||$10,375|
|Divide by average Inflation Rate (3%)||1.03|
|Net after Taxes & Inflation||$10,073|
|Return After Taxes & Inflation||0.72%|
Hmm, taxes and inflation make quite a difference don’t they? Our 5% is now less than 1%!
Now obviously, we only have any control over two of the three variables. Since we cannot control rates of inflation, our work to ensure our returns are adequate and that taxes do not unnecessarily eat away at our earnings is all the more important.