Taxes, Inflation, and Your Investment Returns

Taxes and inflation can significantly impact your investment returns, both in the near-term and over time.

At a high level, excess capital gains taxes can chip away at your investment returns year after year. Meanwhile, inflation affects your purchasing power—that is, the amount of goods and services your dollars can buy. As your dollars become less valuable, you need to earn above-average returns from your investments to maintain your purchasing power and lifestyle goals in retirement.

Thus, it’s important for investors to pay careful attention to their asset mix and the potential cost of their investment decisions. Fortunately, there are strategies you can leverage to minimize the negative affect of taxes and inflation on your investment returns and maximize your results over time.

#1: Prioritize tax-advantaged accounts to maximize your investment returns.

In general, there are two main types of investment accounts: qualified accounts and non-qualified accounts.

Qualified accounts include popular account types like 401(k)s, IRAs, HSAs, and 529 plans. These accounts have unique tax advantages that can provide a meaningful tailwind for your investment results.

While the benefits vary by account, the main advantage is that your money can grow tax-free in a qualified account. That means you don’t have to pay capital gains taxes when you realize gains in your portfolio. In some cases, your contributions and withdrawals are tax-free as well.

Alternatively, a non-qualified account is a taxable brokerage account with no unique tax advantages. In other words, trades that generate gains or losses in this type of account impact your investment returns and year-end tax bill. Investors also need to pay taxes on dividends, interest, and other distributions.

To maximize your investment results, consider taking advantage of qualified accounts when possible. These account types often have annual contribution limits, so you may not be able to use them exclusively. However, the more money you can invest in qualified accounts, the lesser the impact taxes will have on your investment results over time.

#2: Design and implement an investment portfolio that accounts for inflation.

Put simply, inflation increases the prices of goods and services over time. For example, you could buy a movie ticket for just $0.25 back in 1924. Today, you can expect to pay closer to $12-$13 per ticket.

Though inflation is always present, the inflation rate varies over time. For many years prior to the Covid-19 pandemic, inflation was largely negligible and had little effect on consumers and investors. However, due to the economic impact of the pandemic and other factors, inflation levels have been sky-high of late.

Yet on average, inflation has been between 2%-3% per year over the last 100+ years. Therefore, investors must be aware of the impact inflation can have on investment returns over time and take steps to combat it. Otherwise, you risk falling short of your financial goals.

Indeed, your optimal mix of asset classes and investments depends on factors like your age, financial goals, and risk tolerance. But in general, investing in stocks and other growth-oriented assets like commodities has proven to be an effective inflation hedge over time. A financial professional can help you design a portfolio that’s aligned with your needs and objectives.

#3: Consider hiring a trusted financial advisor to help you manage taxes and inflation.

Lastly, DIY financial planning and investment management often comes with costly side effects. If you’re currently going it alone, consider hiring a trusted financial advisor. Not only can your financial advisor help you proactively minimize the effects of taxes and inflation on your portfolio, but they can also help you develop a long-term financial plan to help you successfully reach your financial goals.

At Milestone Asset Management Group, we specialize in helping our clients plan for a healthy and secure retirement while handling all of their tax planning, preparation, and estate planning needs in-house. We know our clients are busy balancing work and family life, often leaving little time to manage their own money. We also understand the importance of a solid financial plan, especially when accounting for taxes, inflation, and other external factors.

If you’re interested in learning more about how we help our clients, please schedule a complimentary call with a member of our team. We’d love to hear from you.