How Tax & Inflation eat my Investments' Return

Hi All,

Hmm.. tough time, specially with these monsters called "Tax" and ever rising "Inflation" around. They resemble "Piranhas" in eating up return on my investments. Here, how they are...

Impact of Tax alone

Considering only "Income Tax" for now, suppose I invest $1000 in 1 year Bank Fixed Deposit fetching around 10% nominal interest rate compounded annually and my little income falls into 10% tax slab.

After 1 year, invested $1000 fetching 10% return becomes (1+0.10)*$1000 = $1100,
making my nominal gain $1100-$1000 = $100

But due to tax, Gain after Tax = $100(1-0.10)= $90
i.e my effective return(after tax) will be $90/$1000 = 9%

So, tax eats up my 1% return for the given scenario.


Impact of Inflation alone

Considering same investment of $1000 in 1 year Bank Fixed Deposit fetching around 10% nominal interest rate compounded annually and assuming annual inflation rate of 10%.

After 1 year, invested $1000 fetching 10% return becomes (1+0.10)*$1000 = $1100

But due to inflation, the purchasing power of $1100 after one year is same as purchasing power of $1100/(1+0.10) = $1000 right now. That means, with 10% inflation and 10% return on investment, my effective return is 0%, yes a big "ZERO" or In other words, my purchasing power remains the same.

So, inflation eats up my whole return for the given scenario.


Combined Impact of Tax and Inflation

Considering same example, investing $1000 in 1 year Bank Fixed Deposit fetching around 10% nominal interest rate compounded annually, my little income falls into 10% tax slab and assuming annual inflation rate of 10%.

After 1 year, invested $1000 fetching 10% return becomes (1+0.10)*$1000 = $1100,
making my nominal gain $1100-$1000 = $100

But due to tax, Gain after Tax = $100(1-0.10)= $90, and after-tax inflow will be $1090.

Now, its reduced purchasing power due to inflation is given by $1090/(1+0.10) = $990.91, i.e net return after tax and inflation will ($990.91-$1000)/$1000 = -0.91%

It means, in actual I am losing my money(by 0.91% a year), if I invest in current scenario.

So, Does it mean that I stop investing ???

No, because if I don't invest, then considering 10% inflation rate, my uninvested amount $1000 becomes $1000/(1+0.10) = $909.09 after 1 year and that means, I'll be losing my money/purchasing power by 9% which is 10 times higher than 0.9%.

I should keep on investing and try to invest in an alternative that can fetch higher return to nullify the combined effect of tax and inflation.

It should fetch return higher than {[(1-tax rate)*nominal interest rate]- inflation rate}/(1+inflation rate), in order to have effective gain over an investment.


Be a smart investor rather than being just an investor... Hope it was worth to read...  !!

Original Article : http://www.qondio.com/how-tax-inflation-eat-my-investments-return