Inflation and Taxes


Inflation is the persistent increase in the cost of goods and services. It's the main reason why a nickel won't get you in to see a movie anymore. The Consumer Price Index (CPI), the most popular measure for inflation, states the rise or decline (deflation) in costs as a yearly percentage. For your purchasing power to grow in "real" terms, your returns must outpace the inflation rate.

When comparing investments, it's crucial that you take into account the impact of taxes. For instance, there are both taxable and tax-free bonds. The taxable bonds usually pay higher interest than tax-free bonds, but you have to pay taxes on any income you receive. Depending on your tax bracket, your net returns from a taxable investment may not be greater, and may even be less, than lower-yielding tax-free investments.

There are also tax-deferred accounts, such as traditional Individual Retirement Accounts (IRAs), that allow the earnings on your investments to grow tax-deferred until you begin making withdrawals at a certain age. By maximizing your net returns, you will have more money to continue investing and growing. Keep in mind that with few exceptions, withdrawals are taxed as ordinary income and may be subject to a federal 10% penalty prior to age 59½.

Unlike traditional IRAs where contributions may be tax-deductible, contributions to the Roth IRA are not tax-deductible. Indeed, Qualified Roth IRA distributions may be subject to state and local taxes. However, if you meet certain conditions, withdrawals from a Roth IRA are completely without penalty and federal income tax. And unlike a traditional IRA, you can continue to make contributions to a Roth IRA no matter how old you are, as long as you still have earned income.

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