From Here to Financial Happiness

Day Forty Two Clearing the Hurdle

It feels good when our various savings and investment accounts increase in value. But are we actually making financial progress? To answer that question, we need to consider two other factors: taxes and inflation.

Let's say we buy a bond in our taxable account that yields 4%. If we pay taxes at a 22% or 24% marginal rate, we'd lose roughly a quarter of our interest to the taxman, leaving us with an after‐tax yield of 3%. That might not seem so bad – unless inflation is also 3%, in which case we're just running in place. We may feel better because our account's value has increased. But this is what's called a money illusion, and we are, in truth, no better off.

Yesterday, I encouraged you to move excess cash out of your checking account and into a high‐yield savings account. If you'll need to spend the money soon, that's probably as much risk as you can reasonably take, and it'll allow you to earn some interest. But unfortunately, the interest you earn likely won't come close to compensating for the hit from inflation and taxes.

Instead, if you want to overcome those two threats and see your money grow over the long haul, you need to take more risk. Bonds may help you beat back the threat from inflation and taxes, especially if you buy your bonds in a tax‐deferred or tax‐free retirement account. But if you really want a good shot at outpacing inflation and taxes, you need to take even more risk – by going from lender to owner. That means purchasing ...