Taxes & Inflation

Generally, your financial goals, risk tolerance and investment horizon take precedence over tax considerations in setting up your asset allocation.
Your financial goals influence how much you want to save. Your risk tolerance helps you to identify the types of investments you're willing to make in order to reach those goals. Your investment horizon determines how long can save for those goals.
More than likely, you are already using tax-advantaged accounts to save for your retirement or perhaps a child's college education. Tax-advantaged retirement accounts include regular IRAs, Roth IRAs and 401(k) plans. College savings plans and education savings accounts are tax-favored accounts used to save for college.
Tax-advantaged accounts can be opened at a bank or brokerage. You buy and sell mutual funds and other securities with these accounts much as you would for a taxable account. Since a 401(k) plan is sponsored by your employer, you're likely to have a narrower selection of mutual funds and other investments to choose from. Similarly, college savings plans typically offer a limited number of mutual funds.
If you're buying and selling mutual funds for a taxable account, keep in mind that income and capital gains are taxed every year. Some investors seek to use taxable accounts for investments that generate less income and tax-advantaged accounts for investments that generate more income. You may wish to consult a financial adviser for advice that is specific to your circumstances.
If you're buying and selling mutual funds for a tax-advantaged account, tax considerations are less important since taxes on any capital gains and income are deferred until you begin to use the money.
Inflation: a hidden tax
Inflation cuts into the value of your investments the way taxes cut into your investment returns. As a result, it is sometimes called a "hidden" tax. Inflation has averaged about 3% a year over the past decade. This may not sound like a lot, but consider this: 10 years of 3% annual inflation means that $100,000 today will only be worth about $74,400 then.
Inflation is bad for stocks and bonds. It raises prices that companies have to pay for everything from raw materials to labor, squeezing profits. Lower profits hurt stock prices. Inflation -- or the prospect of it - means higher interest rates are around the corner. The prospect for higher interest rates sends markets into a tizzy: Bond prices suffer as investors demand higher coupon rates to keep up with those paid on newly issued bonds. Stock prices generally fall as investors look for business costs to increase.
Inflation often results in investors rebalancing their portfolios. They tend to invest in variable-rate deposits and money market securities when inflation is higher, taking money out of stocks and bonds. When inflation subsides, interest rates decline and investors rotate back into stocks and bonds. (We ignore investments in other asset classes such as real estate or precious metals.)
Two major indicators of inflation are the consumer price index and producer price index. A yearly increase of more than 3% for either index often portends higher interest rates since economists often view that much of a climb to be unsustainable. Other inflation barometers include the level of bond yields, changes in credit spreads between high- and lower-quality bonds, and moves by the Federal Reserve to hike the fed funds rate. (This includes a shift in the Fed's bias towards future rate hikes.)
This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Updated: January 2004
2008-07-21 14:30:55
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