The Taxman and Inflation

There are two more hurdles you must take into consideration: taxes and inflation. You will pay taxes on any interest you earn. These taxes are used on both the federal and state levels to fund the government. Depending on your income, you could contribute as much as 30% of your earnings to taxes.

Inflation Graph

Inflation saps the growth of your money because in inflationary periods, the value of money decreases over time. Essentially, inflation occurs when the prices of goods and services rise due to decreased supply and increased demand within the economy. Historically, inflation has grown at a rate of 3% each year. Let's look at an example. Say you bought a soda today for $1. Due to inflation, next year that soda may cost you $1.03. In ten years that soda might cost you $1.30. Of course, these increases are relatively small, but imagine the majority of the products you buy going up in price at the same time. This will be particularly difficult if you aren't getting better than a 3% return on the money you have in the bank. If you were earning 2% interest, your money would be growing at a rate 1% behind inflation. If you saved the dollar for soda and were earning 2% interest on it, next year that dollar would be worth $1.02; in ten years that dollar would be worth $1.20.

When you want your money to grow, you have to be sure that the return, or interest, is greater than the taxes you will pay and that your interest rate is always higher than the rate of inflation.