Money in the bank: Interest rates, inflation, and taxes
Saving for the future by keeping money in the bank? A lot of it? It's a satisfactory feeling to see the money grow. But is it a sound investment advice? Mostly no. A lot of us earn, spend, and save the rest in the bank - perched safely in some savings account. Though the net amount of money may increase in the account over the years, your buying power may be decreasing. Why, you ask?
This happens primarily due to inflation and taxes. A positive rate of inflation means that what you buy today will take more money to buy tomorrow. Though inflation is mostly positive, during recessions it's not uncommon to see a negative inflation. Different countries may have different rates of inflation, depending upon several factors. Central Banks, Reserve Banks, or Federal Reserves try to keep inflation in check or at a targeted level through monetary and fiscal policies.
Suppose the inflation is at 2% per annum. If you buy something for $100 today, you will need $102 for the same thing next year. Different nations have different departments/agencies that measure inflation through price surveys and by collecting data about price levels of different commodities and services. In U.S., Bureau of Labor Statistics's Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. The data can be found on the site: http://www.bls.gov/cpi/
When you pay taxes on the interest earned on the money, it is on the nominal money, without accounting for the effect of inflation. Though the actual buying capacity of the money may have decreased due to inflation, the government taxes you on the money you see in the account, without accounting for the decreased buying power of the money due to inflation. To account for your actual savings or your actual buying capacity, you should account for both - inflation and taxes.
Suppose you earn interest at r%, have a tax rate of t% and the actual inflation is i%, your actual buying power after one year will be:
actual interest rate = r*(1-t) - i
Though you see your money growing at the rate of r*(1-t)% over the years, the buying power of the money will be much less due to inflation.
Let's consider two scenarios and see the effect of inflation and taxes on actual savings in U.S. and India:
In India, banks usually pay around 8.5% interest rates and the tax rates are usually around 30%(though there are multiple tax brackets). With an inflation rate of around 6%, the actual savings are:
Actual rate = 8.5*(1 - 0.3) - 6 = -0.05%
You are losing money by keeping it in the bank at around -0.05%.
In US, typical interest rates are around 0.1%, CPI for May, 2016 was 0.4% and with 30% tax rate(with different tax brackets), the effect on savings are
Actual rate = .1*(1-.3) - .4 = -0.33%
You are losing money with a -0.33% rate per year by "saving it in the bank."
Hmm... Keeping money in the bank doesn't sound that good now, or does it?
Depending upon your risk tolerance and investment horizon, there may be other safer alternatives in which your money may actually grow. Talk to an investment advisor or do some research for exploring different alternatives.