Inflation Can Be A Silent Killer For Retirement Portfolios

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Includes: JNJ, PG, XOM
by: Doug Carey
Summary

Inflation is a stealth tax on our assets and most people have no idea how big the impact is.

Inflation impacts everything from social security taxes to capital gains taxes.

If inflation reverts back to levels we saw a decade ago, many people will be in trouble.

There are so many moving parts when it comes to a retirement plan and lots of assumptions that go into it. Most people who really take an interest in their retirement situation like to run a variety of scenarios. These scenarios normally include things like reducing annual return assumptions, changing the date of retirement, increasing or decreasing expenses in retirement, and changing life expectancy.

One variable that probably does not get enough attention is the inflation rate. It's easy to understand that as inflation rises, so do people's expenses. But the truth of the matter is, it's more complicated than that. Inflation is a stealth tax due to our complex tax system. Federal income tax brackets are indexed to inflation, but many other taxable items are not.

The Inflation Stealth Tax On Social Security

Did you know that you are double-taxed on Social Security payments? You pay income taxes on that portion of your salary that goes to the Social Security portion of the FICA tax. For most people, the amount of their salary that is taken out for Social Security is 6.2%. Again, that money is taken out of your paycheck and it is also included as your taxable income for the year. Now for the really painful part: When you receive Social Security after you retire, you will pay income taxes on it again! Read that one more time. If you don't believe me, just read this article about it.

Now that your blood is boiling about being double-taxed on Social Security, there is more to it than that. The tax brackets for Social Security are not indexed to inflation. So soon enough, we will all be paying the maximum tax on our Social Security benefits. This is part of the inflation stealth tax.

The Inflation Stealth Tax On Capital Gains

Let's say you own a real estate investment property that you rent out. You pay $200,000 for it in the year 2017. In 20 years, you decide to sell it. Over this time, your housing market has just kept up with inflation of 2.5% per year. Over 20 years, this is 64% compounded inflation. Do you think you get to write that off as an expense? Nope. You will pay the capital gains rate of 15% (for most people) on that phantom 64% "gain". This amounts to $19,200 in taxes for a gain that did not really occur because it's all due to inflation. The real increase in that property's value was $0, yet you still had to fork over $19,200 to Uncle Sam. And if you guessed that this same problem occurs with stocks, you're right.

How Inflation Impacts Your Retirement

Now that we're all good and angry/worried/ready to protest, let's take a look at how increasing rates of inflation can impact a person's retirement situation. It's vitally important to understand how your retirement portfolio would be impacted by the inflation stealth tax.

Let's look at a sample case study. Here are my base case assumptions:

Inflation (CPI)

2.0%

Current Age of Both People

45

Age Of Retirement

62

Age When Both People Have Passed Away

90

Social Security at age 67 (combined)

$45,000 per year

Average Savings Rate

$10,000 per year

Total Investment Balance Today

$700,000

Recurring Annual Expenses in Retirement

$65,000

Investment Mix

70% U.S. Value Stocks, 30% Medium Term Treasuries

Investment Location

25% in taxable accounts, 75% in IRAs

Return Assumption Value Stocks

6% per year

Standard Deviation Value Stocks

16.20%

Return Assumption Treasuries

2.5% per year

Standard Deviation Treasuries

7.20%

I ran this retirement plan in our WealthTrace Financial & Retirement Planner, which you can use as well. One important note here is that I also increased the annual return assumptions for all of their assets. I did this so we can isolate the impact inflation has on their taxes. Plus, in general, stocks and (over the long run) bonds see their returns move with inflation. Here are the results at a variety of different inflation rates:

Inflation Rate

Dollar Amount Left At Age 90

Probability Of Never Running Out Of Money

2.0%

758,000

64%

2.5%

744,000

63%

3.0%

730,000

62%

3.5%

719,000

61%

4.0%

707,000

60%

If inflation is 2% higher than expected each year, this couple's nest egg declines by about $50,000. This isn't great, but not a terrible situation for them either. But this isn't the end of the analysis.

Inflation Is Worse For Taxable Accounts

Notice in my first case study that 75% of their money was in tax-deferred IRAs. What would happen if 75% of their money was in taxable accounts instead? I ran the exact same plan and found the following:

Inflation Rate

Dollar Amount Left At Age 90

Probability Of Never Running Out Of Money

2.0%

555,000

54%

2.5%

502,000

52%

3.0%

454,000

50%

3.5%

425,000

48%

4.0%

394,000

46%

The drop in their nest egg is now $161,000. This is more than triple the decline we saw in the first run where 75% of their money was in IRAs. This makes sense due to the tax-deferred nature of IRAs.

The Lesson

There are a few lessons we learned while running these enlightening scenarios. First, you should max out your contributions to your 401(k) plan and/or IRA. Second, do not take today's relatively low inflation for granted. In 2005 and 2008, we saw inflation rates of over 4%. Third, your investments must keep up with inflation.

Keeping Up With Inflation

I like to hedge against inflation with dividend-growth stocks which have easily kept their dividend growth in line with inflation and more. Some of my favorite companies in this regard are Johnson & Johnson (NYSE:JNJ), Exxon (NYSE:XOM), and Procter & Gamble (NYSE:PG). The worst thing you could own if inflation takes off is long-term bonds. Imagine locking in a 30-year treasury yield today of 3% and inflation moves to 4%. You would be locking in a -1% rate of return for 30 years, and to add insult to injury, you would still pay taxes on the income in taxable accounts.

Disclosure: I am/we are long JNJ, XOM, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.