What return are you really earning on your money?
By: Duane J. Silbernagel
If you’re like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you’ll need to understand the difference between nominal return and real return, and how that difference can affect your ability to target financial goals.
Let’s say you have a certificate of deposit (CD) that’s about to expire. The yield on the new three-year CD you’re considering is 1.5%.
But that 1.5% is the CD’s nominal rate of return; it doesn’t account for inflation or taxes. If you’re taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you’re earning something.
However, you also need to consider the purchasing power of the interest that the CD pays. Even though inflation is relatively low today, it can still affect your purchasing power, especially over time. Let’s say that consumer prices have gone up by 1% over the past year and you adjust your 1.08% after-tax return for inflation. Suddenly, you’re barely breaking even on your investment.
What’s left after the impact of inflation and taxes is your real return, because that’s what you’re really earning in actual purchasing power. If the nominal return on an investment is low enough, the real return can actually be negative, depending on your tax bracket and the inflation rate over time. Though this hypothetical example doesn’t represent the performance of any actual investment, it illustrates the importance of understanding what you’re really earning.
Knowing the difference between nominal and real return may help you make better decisions when it comes to investing your money. You’ll want to choose investments that match your financial goals and tolerance for risk. In some cases, the security an investment offers may be important enough that you’re willing to accept a low real return; in other cases, you may choose an investment that has the potential for a higher real return but carries a higher degree of risk.
I hope you found this beneficial and informational. For more information about me and my services, visit my website:
Thank you for your interest.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Waddell & Reed does not provide legal or tax advice. This information is prepared by an independent third party, Broadridge Investor Communication Solutions, Inc. and is provided for informational and educational purposes only. Waddell & Reed believes the information has been obtained from sources considered to be reliable, but does not guarantee the accuracy of the information provided. This information is not meant to be a complete summary or statement of all available data necessary for making financial or investment decisions and does not constitute a recommendation. Please consult with a tax professional regarding your personal situation prior to making any financial related decisions. Also note that the information provided may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. Neither Waddell & Reed, Inc., nor its Financial Advisors give tax, legal, or accounting advice. Nothing contained herein is intended as a solicitation or an offer to buy or sell any product or service mentioned and they may not be suitable for all investors.
Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322 or via email at DSilbernagel@wradvisors.com.
Copyright 2015 – Broadridge Investor Communication Solutions, Inc.
Waddell& Reed is not affiliated with www.newslincolncounty.com website and is not responsible for any other content posted to this website. (08/15)