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Preservation of capital in the face of high inflation requires tax-sheltered gains [ClearOnMoney]
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Preservation of capital in the face of high inflation requires tax-sheltered gains

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Commentary

Preservation of capital in the face of high inflation requires tax-sheltered gains

23 May 2012 by Jim Fickett.

Under conditions of inflation, i.e. essentially always, the Internal Revenue Service taxes phantom gains that are really just redonominations in a cheaper dollar. It follows from this that preservation of capital under moderate inflation is challenging, and under high inflation impossible, unless one has an appropriate tax shelter. Appropriate tax shelters can include not just IRAs and 401(k)s, but also real property and some long-term stock holdings.

The following analysis is simple and straightforward, but I've not seen it explained clearly elsewhere, so here we go.

Consider a non-tax-sheltered investment, in which one is compensated at a nominal rate a little greater than the inflation rate, so that at the end of the year you have the savings you started with at the beginning of the year, plus your nominal return, less your tax. The difference between your savings at the end of the year and your savings at the start of the year is

savings_start*(inflation_rate + real_gain_rate) * (1 - tax_rate)

You want to at least break even, that is, you want this difference to at least equal savings_start*inflation_rate. You break even if

(inflation_rate + real_gain_rate) * (1 - tax_rate) = inflation_rate

Or

real_gain_rate = (inflation_rate * tax_rate) / (1 - tax_rate)

Let's look at some examples. Assume, as a fairly representative case, an overall tax rate (federal + state) of 20%.

Inflation rate Break-even real gain rate Break-even nominal gain rate
2% 0.5% 2.5%
3% 0.8% 3.8%
5% 1.3% 6.3%
10% 2.5% 12.5%
20% 5.0% 25.0%
100% 25.0% 125.0%

During the most recent episode of serious inflation in the US, in the 1970s and 1980s, there were several years when the inflation rate was above 10% (US CPI). Typical long-term real returns in equities are about 4%, and for bonds the number is lower (Equity returns are not as high as most people think). So at 10% inflation, which is not hard to imagine since it has been recently observed, most of the real gain on typical investments is eaten up just paying the taxman for illusory gains. At 100% inflation, hard to imagine under current conditions in the US but not uncommon in the broad sweep of history, one needs an impossible 25% real return just to stay even.

To get round this problem, one needs the illusory gain from inflation not to appear as income. This is obviously accomplished by a tax-sheltered retirement account such as an IRA. But it can also be accomplished in other ways. As long as one holds a capital asset such as a commodity, real property, or equities, one is not taxed on the capital gain. Any income produced, such as useful space provided by a building, or a harvest from a forest or farm, may be taxed, or it may not be, if it is used by the owner.

How you should make use of these facts depends on how bad you think inflation might get. Personally, I will be surprised if we do not see inflation in the US worse than that of the 70s and 80s. And I would not be at all surprised to see a hyperinflation. A hyperinflation is so disruptive that many businesses do not survive. If you think hyperinflation is a serious possibility, it might be best to move towards avoiding the US monetary system entirely: buy a farm you can live on, for example, or equities of companies based in more prudent nations (e.g. Canada or Switzerland). If you think merely high inflation is the main risk, then it may be enough to defer any gains due purely to inflation, via long term holdings in, for example, the equities of solid companies, or real property that you can rent out.

The questions here are not easy, but should not be avoided. One way or another, the inability of Congress to face reality will come home to roost, and high inflation is the most likely outcome. Once everyone realizes what is happening, it will be too late to buy the more attractive assets.