One of the things I try to stress in my financial literacy class for educators is the difference between savings and investments. Savings is more for the short-term, to deal with the expected expenses that arise. Investments are longer term, for longer-term goals (perhaps purchasing a house, paying for a college education, or retiring).
Early on in the class one of the topics we cover is bank accounts, including that you should be getting market rates of return on your savings account. In pretty much every class some of the participants then talk about their savings accounts as “investments”, which leads to the conversation about the difference. I always find it interesting considering how many people love to talk (complain) about inflation that many of those very same people don’t seem to connect that to their rate of return on their savings. There seems to be a disconnect between their understanding that inflation makes the cost of things go up, and their lack of understanding that inflation also makes their savings accounts lose purchasing power over time. They think of the interest earnings on their savings as “separate” from inflation and generally seem to think their money is “growing.”
So I thought I’d write this short (for me, anyway) post as a reference that I can direct them to when we have this conversation. As I’m writing this, most high yield savings accounts have an interest rate in the 3% range, and money market accounts at places like Vanguard and Fidelity are around 3.5%. To be clear, I want folks to have their savings in places like these instead of banks that are taking advantage of them. But it’s helpful (I hope) to do a little math here. We live in Colorado, so have a flat state income tax of 4.4%. That means for folks who are in the 22% marginal federal tax bracket in Colorado, the interest you earn on your savings account is subject to a total tax of 26.4%. Which means that the 3% you might be earning on your high yield savings account is actually a net of about 2.2% (after taxes). That means that if inflation is at least 2.2% right now (which it is), then you are losing money on your savings (the historical average inflation is about 3.3%). Yes, the nominal amount in your savings account is increasing, but it’s purchasing power is actually decreasing.
This is not an argument against having savings (although it is an argument against having too much in savings), but rather an argument for investing. The long-term nominal annual return of U.S. stocks is right around 10% (depends a bit on when you start the measurement). If those investments are in a taxable brokerage account, you will owe some taxes as well that will reduce your after-tax earnings. But these taxes are different because qualified dividends and long-term capital gains are taxed at preferential rates, and capital gains taxes aren’t assessed until you sell and realize the gains (eliminating some tax drag). For most folks, that rate is 15% for qualified dividends and long-term capital gains (for some it’s 0%, for high earners it’s 20%). Ordinary dividends are taxed at ordinary income rates (so 22% in this example). For the purposes of this post, we’ll assume a 1.5% dividend yield and the rest of the growth is from capital appreciation. To keep it simple, we’ll assume all dividends are qualified, although in reality you would likely have some ordinary dividends which would reduce your after-tax return slightly. When you add in Colorado’s 4.4% tax rate (no preferential rate for capital gains), that means that the 10% you earn is reduced to about 8%. When you subtract off the long-term average inflation, the real return (“real” meaning adjusted for inflation, so adequately reflects your purchasing power) is about 4.7%.
That means your investments are growing (in this example, on average) 4.7% annually after taxes and inflation, as opposed to your savings declining by about 1.1% annually. When this compounds over time, the differences can be enormous. Here’s a quick spreadsheet to illustrate, with the following assumptions:
- Initial Amount: $10,000
- Savings Interest Rate: 3%
- Investment Return Rate: 10%
- Inflation Rate: 3.3%
- Marginal Federal Tax Bracket: 22%
- Federal Capital Gains Tax Bracket: 15%
- Assumed Annual Dividend Yield: 1.5%
- Colorado State Tax Rate: 4.4%
What does this look like after 20 years? Your after-tax savings balance is $15,447, so a “gain” of $5,447. But the inflation-adjusted balance, your purchasing power, is only $7,911, a loss of $2,089. If instead you invested it, your after-tax investment balance would be $66,920, a “gain” of $56,920. But that gain includes unrealized capital gains that will eventually get taxed when you sell (unless you hold until death, when you get a step-up in basis and owe no taxes on the gains), plus you have to adjust for inflation. When adjusted for inflation and the eventual tax if you sell before death, the purchasing power in your investment account is $29,393, a gain of $19,393. What about after 30 years? 40 years?
To be sure, this is a simplified spreadsheet with a lot of assumptions But it’s pretty clear why saving isn’t investing, and why investing is our only hope of keeping ahead of inflation. So, by all means, keep enough in your savings that you are comfortable meeting your ongoing expenses and/or short-term goals. But for everything that is longer term, you need to be investing, not just saving.