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Keeping More of What You Make: Two Demons Eating Up Your Investment Earnings


Keeping More of What You Make: Two Demons Eating Up Your Investment Earnings

Thirty years ago in a small conference room in Connecticut I was teaching a group of employees of the soon-to-be defunct American Cyanamid how to plan for their future when the business went away.

A surprising but extremely important lesson for all in attendance came from a 66-year-old factory worker who had never made more than $60,000. In 1949, however, he saved $500, put it into a mutual fund, and then invested $100 every month until that day in 1986.

Guess what he had to live on in retirement?  If you guessed $2.3 million, you are correct. If in 1986 he invested that $2.3 million in 30-year government bonds, he would have had annual interest income in excess of $80,000, and be able to pass the $2.3 million in principal to his kids when he died.

Multiple lessons can be learned from this story. The first is, “It matters not how much you make, but how much you keep” (author unknown). If the factory worker had doubled his wages  but did not save, he would not have been able to retire in 1986.

When you earn money, saving some of it helps assure you have sufficient funds in the future to meet your goals–no surprise there. But it is also important to make sure the money invested nets as much as possible within your risk guidelines (1).

Two demons eat up what you earn on your investments:

  1. Taxes

  2. Inflation

Inflation has been low since 2009, and most economists aren’t expecting it to go up much anytime soon. According to, inflation rates over the last decade had a high in 2008, exceeding 5%. The same source believes last year’s inflation rate was only 2%, and that it will slowly grow to 2.8% by 2020.


What does that mean? Just that if you assume a 2% inflation rate, what costs you $100 today will cost you $102 in a year. Or slightly above $108 in 2020. Your portfolio needs to net a return of 2% each year (or whatever each year’s inflation rate is), or you will effectively go backwards.

Today, the bigger demon to investment returns is taxation. Let’s deal with what we know. Federal tax rates are as high as 39.6% on income, 20% on capital gains and, to pay for Obamacare, another 3.8% of net investment income tax is tacked on for high-earners (the threshold for married filing jointly is $250,000). Throw in state income taxes, if you live in a high tax state like New Jersey,  you can easily round that up to about 50% on earned income.

How do you calculate what you make on your accounts and what is the best investment to make to have the most to keep? First let’s separate the idea of where you invest versus what you invest in. An IRA or a 401(k) is a place to make your investments, and Facebook stock is a type of investment.


My opinion is the best place to invest is in a Roth IRA (if you can–there are limits based on your income–$194,000 for joint filers in 2016) because, although contributions to a Roth are not deductible, there is no tax on the earnings while it is building or when you take money out. The principal isn’t taxed either, since you didn’t deduct the contributions when you made them.  Therefore, if you make a 6% return, you keep the whole 6%.

The maximum you can save per year in a Roth is $6,500 (assuming you are at least 50; otherwise it’s $5,500). This may be significantly less than you are able to and need to save; where you invest the additional amount is extremely important.

Table 1 below shows how earning 6% in various investments have different net returns after tax. Column one is the type of investment and the return example short term gain on stock. Column two has the earnings stable at 6% although we would expect each investment would have a different return. Tax in column three (3) is based on the type of income and our average rates we reference above. Column four (4) is the net after subtracting the tax Column five (5) of the table calculates based on the net return how long before you double your investment. and the last column shows that a Roth doubles your investment at 12 years with these rates of return.

* This table contains forward looking data that reflect management’s current views with respect to future events. 

What you invest makes a difference in how much you actually keep. Where you invest also can make a significant difference in the outcome because, for example, “nesting” in the Roth location not an investment itself, is the great equalizer. The chart also gives insight into the additional return you should get to invest in one area versus another.

If you can get a net return (line E) on a tax free bond of 6%(2) then to invest in stocks that are only short-term profits requires a return 43% higher to net the same after-tax return since short-term gains are taxed at the same high rates as earned income. This difference is what we refer to as a “hurdle rate.” If you cannot make a return 43% higher on the stock consistently (not an easy task, to say the least), then don’t bother.

Determining exact location, taxable account versus tax-free or tax deferred accounts as well as which investment becomes increasingly difficult in an ever changing tax and market environment. Professional assistance is recommended. Beacon is happy to provide a non-obligatory look at your risk tolerance, and where you are invested and make recommendations to increase your net investment return.

  1. It is important to access your risk to determine specific investment classes. Go to the Beacon web site and ask for a risk analysis to see where you should be investing
  2. Municipal bonds that are perceived as high risk may be able to get a 6% return. Municipal bonds of high quality municipals is much lower than 6% .
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