Do you recall part I and II blog posts saying that the S&P 500 index has had an average annual return of about 8%? Well, that’s part true.
When you earn interests over your investments (bonds, stocks, ETF or even real estate) you must pay taxes.
So, if you invested for a year in an index fund that replicates the S&P 500, and the yield was 10% for that year, you wouldn’t receive the full 10% return.
If you were in Italy, you’d have to pay 26% on taxes, reducing the return rate from 10% to 7,4%.
In the U.S. the tax burden works differently for investments: depending on your federal tax bracket, you would have to pay from 10% to 39,6% on taxes, plus the state tax.
Important: Remember asking your financial institution how much the return of your investment actually is after taxes. They tend to forget that huge detail, on purpose.
Inflation
Inflation is the increase in cost of living.
While this is a tangible reality for Argentine citizens (Nashdaq article) since they are going to face a 40% inflation rate in 2020, for other countries, it appears not to exist.
In the U.S., the average inflation rate has been around 2% in recent years. Therefore, it’s not as easy to perceive the increase in the cost of living as in Argentina.
Inflation rate is a devour of our investments’ returns.
If you wanted to have the same purchase power in Argentina with the same amount of pesos (currency in Argentina) in a year, you would have to aim at a 40% return investment.
For the U.S., in order to keep up with the inflation rate, you need a 2% annual return investment.
Going back to the hypothetical 10% return on the S&P 500, you would really have an 8% return, due to inflation rate.
It’s more than a little ironic that if you decide to invest in the U.S. treasury bonds, due to their extremely low yield, you will still lose money. Check the number at the official site: Treasury.
There’s still salvation
Every disease has its cure, so let’s try to figure out how to tackle taxes and inflation.
- Inflation: Invest in a strong currency that is less likely to be devalued, like euros €.
- Taxes: Invest in tax-free bonds like government bonds or in a retirement account.
Investing in government’s debt is not as bad as you think
That’s right! Governments like putting their own interests first. Depending on the country, investors on the government’s debt don’t pay taxes.
In Italy, if you invested in government’s securities instead of any other security, you would pay 12,5% on taxes instead of 26%.
In the U.S., investing in Treasury securities (debt instruments issued by the United States Department of the Treasury) is entirely tax free.
Therefore, before comparing any investment option against government’ securities, remember that taxes play a BIG role.
A great retirement account feature
Another possibility to avoid paying big percentages on taxes is investing in retirement accounts. For instance: 401(k) or Roth IRA for the U.S. or fondo pensione for Italy.
Depending on the country, it’s possible to totally avoid paying taxes as long as your investments are in a retirement account.
In Italy you could pay as little as 9% on taxes if you opted for retaining your investment for more than 30 years on the retirement account.
Tax deduction totally depends on your country, so be sure to check that out before considering investing outside of your tax-shelter retirement account.
Paying debt first
As crazy as it could sound, paying your debt first could be an investment.
Not only because having debt increases your interest rate for future loans, but also because taxes don’t apply to debt repayment.
Practical example: Would you rather pay your debt that has an annual 9% interest rate? Or would you invest that money in a fund with a 10% yield?
The 10% yield will be shrunk to 8% if you had to pay 20% on taxes, leaving you with a final yield of 8%. On the other hand, since debt repayment doesn’t pay taxes, your money would have a better use by repaying the 9% interest rate debt.
This also applies to mortgages. Even better: you can get your mortgage interest rate deducted from your annual taxes.
Looking beyond the yield
Sometimes we can find ourselves chasing after the strongest performing investment, overlooking simpler investments.
However, there are other factors, besides risk, that need to be considered: taxes, inflation, commissions, fees, etc.
Financial institutions will hide these factors from you unless you ask. So, next time remember asking for any hidden consideration that could hinder your investment’s return.
This is the end of this series of blog posts.
I hope you liked all the three articles and that you learned something about investments from them.