Mind Over Money Matters

Phony Profits and Phony Prudence

Investing and saving for the future is usually a good thing. But as the poet Burns said, the best laid plans of mice and men oft aft agleigh. Not that mice do any banking or I really understand Gaelic. Still, some things which might strike someone as profitable or prudent, aren't necessarily so.

Inflation Taxation, or How to Be Ahead and Fall Behind at the Same Time

One might imagine getting an investment return greater than inflation keeps you ahead of the game. Not always, the game may be rigged. That's because the tax man only counts the number of dollars and not the value of dollars. To see what I'm getting at, let's run a couple of scenarios.

Let's say you have a capital investment of $100,000 which returns 5% over inflation in a year. Assume a capital gains tax rate of 30%.

Year of No Inflation: Your investment gives you a $5,000 profit. You pay $1,500 in tax leaving $3,500. Your total account is now $103,500. Since there is no inflation this money will buy what it did the year before, so is worth $103,500.

Year of 15% Inflation: Your investment returns a $20,000 profit. You pay $6,000 in tax leaving $14,000. Your total account is now $114,000. Sounds pretty good, right? Yet, because of inflation this money has lost 15% of its purchasing power. Compared to what this amount would buy last year it's now only worth $99,066. You're $934 worse off than last year.

On paper you made $20,000 and the account is at $120,000 before taxes. But because of inflation it's only worth $104,280 in buying power compared to last year. You're really only $4,280 ahead but the IRS taxes you as if you were $20,000 to the good.

Because of inflation in scenario two you are $4,434 worse off than in scenario one, but the IRS has taken $4,500 more in taxes. Adjusted for inflation that's still a $5,214 tax take compared to $1,500 as in scenario one. No wonder the government favors inflation over deflation.

Inflation is a loss on your investment in purchasing power you can't claim as a loss when you do your taxes, but it's real all the same. The tax man gets a windfall when inflation creates phony profits that get taxed like real profits. That's how to be ahead and fall behind at the same time.

Credit Card Monty, or How to be Safe and Sorry at the Same Time

Credit card companies may be thought usurious and underhanded, but they also make money off ignorance. That's because some people keep an "emergency fund" in the bank while carrying credit card debt. But the thing is, there is absolutely no advantage in doing so.

Want proof? Say you have two people named Saver and Payer. Both have $10,000 in the bank, both have a credit card debt of $10,000 at 20% annual interest. Payer pays off the debt, and so has zero savings and zero debt.

The next day both are hit with an emergency expense of $10,000. Having no savings, Payer pays with the credit card and now has zero savings and a $10,000 debt. Saver pays with the "emergency fund" and now has zero savings and a $10,000 debt, the same as Payer. Where's the advantage?

On the other hand, say the emergency doesn't happen for five years. At 20% a year Saver's debt interest is $2,000 annually which adds up to $10,000 after five years. In the meantime Payer, who has no debt to service, has saved that amount. Saver is in the same position as he began, but Payer has $10,000 saved and no debt. When the emergency comes Payer pays it off with the savings without going into debt. Saver also pays it off with savings, but still has a $10,000 debt. Again, where's the advantage?

Even without the emergency and if the interest paid on the savings were 10% annually, after five years compounding the interest Saver would have about $16,000 in the bank while Payer would have just over $12,000. But Saver would still owe $10,000 while Payer owes nothing. Payer is a net $6,000 ahead of Saver. Again, where's the advantage?

Yet many people think it's prudent to keep an "emergency fund" in the bank while maintaining credit card debt. In other words, they pay debt interest 100% of the time in order to not pay debt interest for an emergency which might happen 5% of the time. Does this make any sense?

You have to really like those bonus points to keep yourself in debt this way. Like they don't say, fools and their money cry all the way to the bank. While it's fine to save for a rainy day, if you owe the credit card company at high interest rates it's already pouring.

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