Whenever you’re looking at the return on an investment, you have to take into account the two main drags on your returns, taxes and inflation. This may sound kind of obvious, but I don’t know many people who actually sit and do the calculation. So let’s do it together.
An investor is looking at investing in a 10 year US treasury note in a taxable brokerage account. Sure the 4% yield isn’t very exciting, but at least it’s a certain return. Or is it? Someone in the 25% tax bracket (the average person) will lose 1% right off the top. And right now inflation is running at an annualized rate of 3.5% per year. So 4% – 1% – 3.5% = a 0.5% annual drop in the value of the investment. If it was subject to state income taxes (treasury notes are not) it would be even worse.
Are people crazy buying an investment like that? Actually losing purchasing power of their savings? Not really. Inflation may drop, the treasury notes may be in a tax free IRA, And maybe interest rates could drop even more, making this look like a good deal. But for now it’s a money losing proposition.
An investor should do this calculation with every investment they consider. Knowing how taxes and inflation effect an investment will give you a very different perspective on investments you’re considering.