How Do Taxes and Inflation Affect My Investment Return?

Given the current state of the economy and recent geopolitical events such as the Russian invasion of Ukraine, you may find yourself wondering, “how do taxes and inflation affect my investment return?” To put it in the simplest terms, both taxes and inflation can dramatically impact your investment portfolio … and not just in the short term. The rate of return on long-term investment strategies is also susceptible to increases in inflation and changes in tax laws.

As if to prove this point, this quarter alone has been the worst loss U.S. bonds have seen in over 40 years, leaving many investors to wonder whether now is a good time to buy while others wonder whether they need to sell what is typically referred to as “safe money.”

If you’re working with a good tax and financial advisor, your investing strategy should already plan for turbulent times such as these. But if it doesn’t account for volatile changes in the economy and the effect of taxes, the purchasing power of your portfolio can suffer causing your hard-earned assets to lose their value.

How do taxes affect the rate of return on investments?

At large, taxes reduce your investable income and not considering them as part of both your tax and investment strategy can result in suffering from unforeseen hits on your returns. Although there is no way to get out of paying taxes altogether, there are tactics you can use to reduce their impact across your entire financial plan.

Tax laws differ depending on the type of investment vehicle or account you are invested in and knowing these differences is vital to creating a well-balanced portfolio.

For instance, most non-qualified accounts funded with after tax dollars are fully taxable when invested in vehicles such as stocks, bonds, real estate investment trusts (REITs), mutual funds, and exchange-traded funds (ETFs). The taxes for these investment vehicles are based on the amount you earn through interest, dividends, and capital gains (learn more about capital gains tax in Texas). 

Alternatively, qualified or tax-advantaged investment accounts like 401(k) accounts, IRAs, or 403(b) accounts allow you to make tax-free contributions, and withdrawals are taxed as normal income after a set age.

Because of the complexity of tax laws, it is recommended that you regularly review the laws specific to your portfolio allocation with your wealth manager to decide if changes need to be made. Keep in mind that in addition to federal tax, you may also be subject to state tax based on where you live.

What does inflation do to the stock market?

Inflation refers to the rise in the cost of goods and services such as an increase in the price of used cars, more expensive gas prices, and increases in rent. The U.S. is currently seeing an inflation rate of 8.5% as of March 2022, which is the highest it has been since 1981. Increases in inflation like this can cause the stock market to become volatile while ultimately causing investors to lose their purchasing power.

The impact of inflation on your investment return readily depends on your portfolio allocation and how you play the market. Generally speaking, periods of higher inflation lead to lower equity valuations. Meaning that this year especially, investors should revisit their stock portfolio strategy for the year ahead to consider both short-term and long-term changes on their portfolio allocations.

How to fight inflation and the impact of taxes on your portfolio

When threats of inflation loom alongside stark changes in energy prices, it can be difficult to resist the temptation to be highly reactionary. However, the negative sentiment that affects the stock market is often only temporary and geopolitical shocks tend to be short-lived from a long-term perspective. Instead of panicking, work with your wealth manager to closely monitor your portfolio and remind yourself that tactical management can add incremental returns that benefit your overall investment performance in the long term.

Taxes and inflation are two inevitables that will constantly be working against the purchasing power of your portfolio. Recent changes and the unknown of tomorrow’s market provide you an opportunity to review your financial risk management plan or develop one if you haven’t already done so. Your investment portfolio should be a delicate balance of risk and keeping the value of your portfolio ahead of tax and inflation changes. If it’s not, something needs to change.

Is your investment strategy safe from increases in inflation? Call Avidian Wealth Solutions to create a plan that protects your assets today.

How do taxes and inflation affect my investment return? Both taxes and inflation can be harmful to the purchasing power of your portfolio by reducing the amount of income you have to invest back into your assets. However, an effective investment plan that includes risk management strategies can help you protect your assets, even in volatile markets.

If you need assistance in creating a financial plan that may provide this type of protection, Avidian Wealth Solutions is here to be your partner. We are a Houston-based fiduciary investment management firm assisting clients all over the United States to mitigate risk across all areas of their financial plan including investments, retirement, estates, businesses, and more.

To learn more about how taxes and the recent spike in inflation may impact your investment return, request a meeting today.

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