Investing is often portrayed as a path to financial freedom, with promises of compounding growth turning modest savings into substantial wealth over time. However, lurking in the shadows are two formidable adversaries that can significantly erode your hard-earned returns: taxes and inflation. These “enemies” don’t just nibble away at your gains. They can devour them entirely if not accounted for. In this article, we will examine how taxes and inflation individually and collectively influence real investment returns. Real returns indicate the true increase in purchasing power after accounting for the rising cost of living due to inflation.

We’ll break it down step by step and visualize the difference between nominal (unadjusted) and real (inflation-adjusted) values through a calculated example. By understanding these forces, you can make more informed decisions, such as choosing tax-efficient investments or inflation-hedging assets like stocks or real estate.

Understanding Inflation: The Silent Thief of Purchasing Power

Inflation is the steady rise in prices for goods and services, which reduces your money’s purchasing power. If you invest $1,000 and it grows by 7% in a year, you’d have $1,070. But if inflation is 3%, that $1,070 buys only what $1,039 would have bought at the start of the year. Your real return—what your money is worth in today’s dollars—is about 4% (7% – 3%).

Over time, inflation’s impact compounds. At 3% annual inflation, your money’s purchasing power could be cut in half in about 24 years.

Understanding Taxes: The Government’s Cut of Your Gains

Taxes, like capital gains taxes, take a bite out of your investment profits. In the U.S., long-term capital gains (for assets held over a year) are often taxed at 15% for middle-income investors. Taxes are applied to your nominal gains, not your real gains, so you’re paying tax even on the part of your return that just keeps up with inflation.

For example, with a 7% nominal return on $1,000, your gain is $70. A 15% tax on that gain is $10.50, leaving you with an after-tax nominal return of 5.95% ($59.50 ÷ $1,000).

The Combined Effect: Inflation and Taxes Together

When inflation and taxes team up, they significantly reduce your investment’s true value. Here’s how it works for a $1,000 investment with a 7% nominal return:

1. Taxes first: A 15% capital gains tax on the 7% gain reduces your after-tax nominal return to 5.95% (7% × (1 – 0.15)).
2. Inflation next: Adjust the after-tax return for 3% inflation to find the real after-tax return: ((1 + 5.95%) ÷ (1 + 3%)) – 1 ≈ 2.86%*. This means your $1,000 grows to about $1,028.60 in real purchasing power after one year.

Visualizing the Long-Term Impact

Let’s see how this plays out over 20 years with a $1,000 investment, assuming a steady 7% nominal return, 3% inflation, and a 15% capital gains tax:

• Nominal value: At 7% annual growth, your investment grows to about $3,870.
• After-tax nominal value: Accounting for the 15% tax, the effective growth rate is 5.95%, so your investment reaches about $3,176.
• Real after-tax value: Adjusting the after-tax return for 3% inflation gives a real growth rate of about 2.86%, resulting in a value of around $1,750 in today’s dollars.

Strategies to Combat the Enemies

While you can’t eliminate taxes or inflation, you can mitigate their impact:

1. Tax-Advantaged Accounts: Utilize accounts like 401(k)s, IRAs, and HSAs, where investments can grow tax-deferred or tax-free.
2. Long-Term Investing: Hold investments for over a year to qualify for lower long-term capital gains tax rates.
3. Inflation-Protected Securities: Consider Treasury Inflation-Protected Securities (TIPS) which adjust their principal value based on inflation.
4. Growth-Oriented Investments: Historically, equities (stocks) have provided returns that outpace inflation over the long term.
5. Tax-Loss Harvesting: Strategically sell losing investments to offset capital gains and even a limited amount of ordinary income.

Understanding and planning for the effects of taxes and inflation are steps to help you achieve a financial future and strive for your investments to work efficiently.

As a boutique investment management firm and professional money manager, Trademark Capital specializes in tactical portfolio solutions designed to navigate changing market conditions. We understand the effects that both taxes and inflation can have on investments, and our team is here to help you gain confidence, regardless of market performance.

*A Note on the Math

To calculate the growth of the $1,000 investment over 20 years, we used two standard equations:

1. Compound Interest Formula: This shows how money grows over time at a given annual rate. For the nominal value, we used a 7% rate, resulting in ~$3,870. For the real value, we used 4% (7% minus 3% inflation, as a simple approximation), resulting in ~$2,191. For the after-tax nominal value, we used 5.95% (7% reduced by 15% tax), resulting in ~$3,176. For the after-tax real value, we used 2.86%, resulting in ~$1,750.
2. To calculate the real after-tax return, we used a tax-adjusted version of the Fisher equation, which accounts for inflation’s effect on the after-tax nominal return.

Thank you for reading!

This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Trademark Capital’s investment strategies are built using quantitative, proprietary algorithms that are designed to identify and react to changing market conditions. However, investors should be aware that no investment strategy or risk management technique can guarantee returns or eliminate risk in any given market environment. As with all investments, Trademark Capital Management’s investment strategies are subject to risk and may lose money. The investment strategies presented are not appropriate for every investor and individual clients should review with their financial advisors the terms and conditions and risk involved with specific products or services. Due to our active risk management, our managed portfolios may underperform during bull markets. Past performance is no guarantee of future results.