Inflation, Taxes and Fees, Oh My!

There are many kinds of investments. Investments can be in the stock market, bond market, real estate, precious metals, certificates of deposit (CDs) or small businesses. Investments can also be in mutual funds. Mutual funds are investment opportunities that are comprised of a grouping of stocks and/or bonds as well as a little cash in some instances. Money market accounts and savings accounts are also investments in one sense, but the yield (or interest rate) paid to you for these accounts-- while stable and possibly even FDIC insured-- is also very low. So beware: not every place you can place your hard-earned income is a money maker over time, and some can even be money losers.

Wow, I asked Lewis to read that, and it's pretty dry material! Like the Sahara. Sorry, what I find interesting can be a bit dull at times. What can I say-- I am easily entertained! Moving on--

Collecting! Whether it be art, antiques, cool cars, stamps, jewelry or baseball cards-- is not investing. It's a hobby, where something you love owning may-- or may not-- become more valuable over time than what you spent on it. For the most part, when we tune in to Antiques Roadshow, we are seeing the occasional person who brings in the rare and elusive treasure we all dream of finding hidden in the attic! You are not seeing all the hundreds of people who are not being filmed, the ones who brought in the painting of white-jump-suited Elvis on black velvet that Aunt Wilma got on a road trip through the Smoky Mountains in 1969. So collect what you love and enjoy what you have, but do not count on these items to have any monetary value.

Inflation: it's not just for balloons

Back to money! Right now, the average money market account, savings account and CD are making close to no money whatsoever. Considering the inflation rate so far for 2014 (even at a relatively low 1.7%), keeping money in a money market account will actually lose money over time. Personally, we have a Vanguard money market account that is used as a parking area for liquid assets ('liquid' means those particular assets are available to be converted to actual cash for immediate use and has nothing whatsoever to do with your morning coffee, moisture, the ocean, although they are all awesome in their own right ). We have some liquid assets which we may need to pay bills. This account is electronically linked to our bank's checking account so that cash can easily be transferred from one place to the other quickly if need be.

Inflation occurs when there's an increase in what we pay for goods and services over time. When I was a child in the 1960s, I remember candy bars going up in price from 5 cents to 10 cents-- now that's inflation! Inflation calculators show the buying power of our money over time. So that same candy bar which was a dime in 1967 is now on average 71 cents. The cumulative inflation rate in that span of time was 612.7%.

Not all goods and services have the same inflation rate, though. Inflation on college education tuition has increased disproportionately compared to inflation rates on goods like food, clothing, gas, etc. From 2003-2013 alone, college tuition went up by nearly 80%, almost 2 times faster than even a pricey area like medical care.

According to a NY Times interactive college cost calculator, the average 4 year in-state public school student living on campus paid just over $18,000 per year in 2009 for college, room & board. If the cost of college inflation slows to an annual rate of 1.7% per year, a baby born in 2009 can expect to pay over $56,000 per year (in 2009 dollars) for her freshman year tuition of the exact same kind in 2027. Ouch!

So when making investments, inflation should always be taken into account. Inflation, taxes, and brokerage fees are all insidious places where we may be losing money when making investments.

I'm not writing this to scare anyone, but these are facts worth considering when deciding how to invest money for your future. Whether you're saving for a big event, buying a home, saving for your child's college education, or for retirement, it's a good idea for you to get a real feel for how much money you are really making on your investments.

So let's take a look at how certain factors take a bite out of your investments. In the chart below, you can see the historic rate of return on 5 different types on investments.

Annual Historic Rates of Return: 1926-2012

Past Performance No Guarantee of Future Results; Source: Morningstar 2013

US Treasury Bills ---------3.5%
5-year Fixed term Investments --------------4.8%
Long-term Government Bonds -------------------5.7%
US Large Company Stocks -------------------------------------9.8%
US Small Company Stocks ------------------------------------------------11.9%

Historically, the inflation rate has averaged out to be about 3% over the past 85 years. How does this-- and the taxes we pay-- affect your purchasing power (financial ability to buy stuff)?

Taxes join inflation for a good time

Well, let's say you go for a fund of large US stocks as an investment. Our chart above says that the historic rate of return on this option is 9.8%. Historic charts LOVE to illustrate what the past 10 years have revealed, and they like the nice round number of $10K to be their initial investment.

So if you invest $10,000 (without any additional contributions), you may end up with about $25,500 in just 10 years! That is, until you factor in the following very real considerations:

your state marginal tax bracket (ours is around 6.65%; yours may be more or less)
your federal marginal tax bracket (anywhere from 10%-39.6%)
an estimated annual inflation rate of 3% (remember this varies from year to year; this year's inflation rate is considerably lower)

For Lewis & me, after taking inflation & taxes into account and figuring the average inflation rate of 3%, the purchasing power of this exact same investment is reduced to just $14,500. These factors reduce the return to a much lower 3.7%.

If we decided to go with the more conservative (less risky, but less return than the stock funds) investment of taxable long-term government bonds (which has a 5.7% historical return), the outcome is lower still. No surprise there! Our investment after inflation & taxes are factored in would be approximately 1%. Yes, most likely it's safe, solid and dependable, but awe-inspiring?? Not so much. But it still beats a savings or money market account, not to mention stuffing cash into our mattress.

Taxes are one of the very best reasons for you to invest in your retirement account NOW!!!

First, contributions to retirement accounts such as 401Ks , 403bs (retirement savings programs offered by many employers) and traditional IRAs (individual retirement accounts) are actually subtracted from your taxable income when you file your tax return, which may put you in a lower bracket than you would be if you didn't invest your money.
Second, money you tuck away in retirement accounts AND the money you earn on the investment is not taxed until you withdraw from it upon retirement.
Third, the tax-rate on your saved investments will probably be considerably lower in retirement than it is while you are working, as it is unlikely you will be making as much money. So you may very well be in a lower tax bracket and get to keep more of your investment return!! Yahoo!

Fees: yes, someone else also wants a cut of your money!

I haven't even touched on fees yet, another area where someone has their hand out to take a chunk of your investment money. Buying and selling individual stocks has a price tag which can vary enormously depending on where you choose to do business. As for a mutual fund, you will indirectly pay for its manager, as well as legal expenses, accounting & auditing fees among others. These people make money whether or not the stock market goes up or down. On another day I'll talk about load vs no-load funds, another fee to be aware of while investing. If someone tries to sell you a loaded fund, do not buy it without first truly understanding what the deal is!! In fact I recommend steering clear of loaded funds entirely.

Not all mutual funds of comparable investing categories charge the same amount, either. For example, Vanguard, T. Rowe Price and Fidelity all have retirement funds for the target date of 2030. Year-to-date (as of today), they have made 4.74%, 4.20% and 3.53% respectively.

Their fees, however, are interesting to see: Vanguard's expense ratio is the lowest at 0.17%. Next comes T. Rowe Price at 0.73%, and finally Fidelity's is 1.02%. A fund's expense ratio is the amount your account is charged per year for the pleasure of doing business together. If the mutual fund losses money, guess what?? You still pay.

In this particular case, the fund with the lowest return of 2014 also has the highest fees. This is not always the case, however, so it pays to look into returns over time and expenses in several places. Magazines like Kilplinger's and websites like Morningstar can give insight into investments which can be very helpful. So can each brokerage house's websites, which are often a fountain of information.

Keep in mind...

Also-- in case you missed it on the Morningstar chart above,

"Past performance is no guarantee of future results."

Just because historically the stock market has behaved in certain ways does not mean it will remain a steady slope aiming upwards. In reality, it has been more or less a pretty wavy line, but in general aiming up! Investing is a long-term activity; day trading is not too different from gambling in my humble opinion.

Much of investing comes down to risk vs reward. That speaks to your comfort level in tolerating risk & the unknown of the future. It also comes to diversification. That means not having all your eggs in one basket. But I have to go feed the dogs now.