When looking for a place to stash your emergency reserves, a visit to bankrate.com is probably your best bet. The popular site provides an up to date list of the banks that are currently paying the highest rates on fully liquid, FDIC insured savings accounts, making it easier than ever for savers to find the highest possible interest rates. Right now, the highest savings rates posted on bankrate.com are in the 2.25% range.
But when you earn 2.25%, are you really earning 2.25%? In other words, what are you actually earning on savings after you consider the two archenemies of wealth preservation – taxes and inflation?
Let’s take the example of Joe, who deposits $50,000 into an online savings account earning 2.25%. In one year, he will earn $1,125, leaving him with an account balance of $51,125.
At the end of the year, the bank will send Joe a 1099-INT, requiring him to report the interest earned on his tax return. Assuming a tax rate of 24%, the tax due on these earnings will be $270, leaving him with after-tax earnings of $855, or an account balance of $50,855. That’s still a fairly good return for not doing much work and taking zero risks.
Next, he also must consider the fact that prices are rising while his money is in the bank. According to the Bureau of Labor Statistics, the Consumer Price Index for all goods for the twelve months ending June 30, 2019, increased by 1.6%. Assuming this is a reasonable expectation for inflation over the next twelve months, the $50,855 adjusted for inflation is $50,041, leaving Joe with an after-tax, inflation-adjusted return of 0.08%. At that rate, he will double his money in about 900 years.
However, a more reasonable forecast for inflation might be 2%. If prices rise by 2%, the after-tax, inflation-adjusted value of his savings will be $49,736, a return of about -0.3%. Despite taking the time to locate the best available savings rate, his savings will actually command less purchasing power than it did a year ago.
At higher tax rates, the story only gets worse. At a 2% inflation rate and a marginal rate of 37%, the inflation-adjusted after-tax return declines to -0.6%. When you add in the Net Investment Income Tax (NIIT) of 3.8%, and/or a state income tax, tax rates can approach 45-50%, pushing the return down to about -1%.
Below is a table of inflation-adjusted, after-tax returns of a 2.25% bank savings rate at various tax and inflation rates:
*37% plus 3.8% NIIT plus 6.85% state income tax (NY’s 2nd highest tax bracket)
As you can see, there is a cost to keeping money in the bank, even when you take the time to find the best rates. So, what should you do about this?
For your emergency reserves or any funds, you need in the next few years, there really is nothing you can do. Emergency reserves should be fully liquid and backed by FDIC insurance. Therefore, a low or negative inflation-adjusted after-tax rate of return is probably unavoidable. That being said, here are two ideas.
First of all, avoid over funding your emergency reserve. This requires a good understanding of what your level of emergency reserves should be, and this, in turn, requires a sound, well-thought-out financial plan.
Another possible strategy is to divide your emergency reserve into “tranches,” locating the first tranche in a fully liquid FDIC insurance account and locating a second tranche in a conservative investment portfolio that is likely to produce positive inflation-adjusted after-tax returns. This portfolio will at times experience modest declines in value, but assuming the first tranche is adequately funded, the odds you will need to access the funds in the second tranche are low. Just keep in mind that this strategy is not for everyone and should be implemented carefully as part of a well thought out financial plan.
If you have any questions, please feel free to contact our offices at 561-491-0231.
