We Shall Overcome…

There are two major obstacles one must overcome when investing. No, it’s not Republicans and Democrats, although they have something to do with both obstacles.

The two obstacles are inflation and taxes.

The first obstacle, inflation, has a dramatic effect on your purchasing power over time. While I rarely quote wikipedia.org, I found their opening definition to be quite succinct. In the public’s definition, inflation refers to “a general rise in prices measured against a standard level of purchasing power.” As time goes on, we have all noticed how we just can’t buy what we could with that same dollar bill. Prime examples of how our purchasing power has eroded throughout history include house prices, stamps, gasoline, eggs and milk.

According to the Consumer Price Index (CPI), inflation reared its ugly head most severely in the late 1970’s, exploding into the double digits and peaking at 13% in 1978. Just a few years later in 1982, inflation sunk to its lowest point circling at just over 1%. In fact, inflation has averaged just under 5% over the past 50 years.

What does this mean to you?

If you are not beating a minimum of 5% for a long-term investment, you may be losing money! Historically, stocks, above almost all other investments (most real estate included) have beaten inflation.

Picture my flat hand raised horizontally over my eyes. This is inflation. Now, if you have a CD at the bank offering you something like 3.6% for the next 5 years, picture my hand raised horizontally directly over my chin. Your CD is not even treading water long-term. And, because this CD at the bank is typically invested outside a tax shelter, such as an IRA or Roth IRA, there are taxable consequences to investing in this instrument and hence, a lower net earnings.

Coincidentally, the other obstacle just happens to be taxes.

Your investments will face taxable “issues” should they be placed outside of what the government considers “qualified accounts.” Examples of “qualified accounts” include, but are not limited to: IRAs, Roth IRAs, 401(k), SIMPLE, SEP, 403(b), the old Keoghs & SAR/SEP plans, and certain life insurance policies including annuities. Check with your accountant or Financial Advisor to determine if you qualify for any of the aforementioned. If the case is such that you cannot participate in a “qualified account,” or you’ve reached the maximum contribution limit(s), your investments will face the obstacle of tax. For investments held longer than one year, you may be charged a capital gains tax, which, for 2006, the maximum capital gains rates were 5%, 15%, 25% or 28%, based on income and according to IRS.gov.

Here are a few other tax facts about capital gains and losses taken directly from www.irs.gov.

  • Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.
  • Capital gains and losses are classified as long-term or short-term, depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term.
  • Net capital gain is the amount by which your net long-term capital gain is more than your net short-term capital loss.
  • The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income and are called the maximum capital gains rates.
  • If your capital losses exceed your capital gains, the excess is subtracted from other income on your tax return, up to an annual limit of $3,000 ($1,500 if you are married filing separately).

For more information about reporting capital gains and losses, get Publication 17, Your Federal Income Tax, and Publication 550, Investment Income and Expenses, available on the IRS Web site at IRS.gov or by calling 800-TAX-FORM (800-829-3676).

Should you have your investments for less than one year, your tax may be determined by the gain of your investment and added to your income. (Always consult a tax advisor, accountant, or consultant). This could be as little as nothing, should you make little enough, or, the more you make, the more they take and you could end up paying over 40%, depending on your state tax burden.

The morale of this story, kids, is you must be aware of the bumps in the road if you are to enjoy a smooth ride to your financial destination. By understanding your options of where to place your investments, and thereby beating inflation (stock) and taxes (qualified accounts), you can experience a sound investment, without many accidents.