I want to tell you a story about a business owner named Jack.
Jack had accumulated an extra $100,000 in personal cash that he did not expect to need during the coming year. He was apprehensive about investing in the stock market, so he decided to put the money into a certificate of deposit, much like his father and grandfather had done before him.
Jack contacted his local bank and chose a one-year, FDIC-insured CD paying 4% APY.
The year passed quickly, and Jack earned $4,000 in interest. Assuming that all of the interest was taxed at his 22% federal income tax rate, he owed $880 in federal taxes. That left him with an after-tax gain of $3,120 and an after-tax value of $103,120.
Jack had not considered the tax consequences when he opened the CD. After taxes, his net return was not 4%. It was 3.12%.
Taxes, however, were only the first silent thief.
In this hypothetical example, inflation over the same year was 3.5%. Something that cost $100,000 at the beginning of the year would cost approximately $103,500 one year later.
Jack had more dollars, but those dollars had slightly less purchasing power. After accounting for both federal taxes and inflation, his real return was approximately negative 0.37%—a loss of about $367 in purchasing power, measured in beginning-of-year dollars.
The lesson for Jack was simple: FDIC insurance could protect his eligible deposits against the failure of an insured bank, but it could not protect what those dollars could buy.
Jack may still have selected an appropriate investment for his risk tolerance, liquidity needs, and timeline, even though it did not keep pace with inflation. The problem was not necessarily the CD. The problem was that Jack made his decision without understanding its likely after-tax, inflation-adjusted return.
An informed decision requires more than asking, “Is my money safe?” It also requires asking, “What will my money be worth after taxes and inflation?”
If you would like to discuss investment options that account for the effects of taxes and inflation and how those options may fit your goals, time horizon, liquidity needs, and tolerance for risk, please contact me.
Disclaimer: This hypothetical example is provided for educational purposes only and is not individualized investment, tax, legal, or financial advice. It uses simplified assumptions and does not account for state or local taxes, individual spending patterns, account ownership, or other circumstances that may affect actual results. Traditional bank CDs may impose penalties for withdrawals before maturity. Brokered CDs sold before maturity may fluctuate in value and generate a gain or loss. FDIC insurance applies only to eligible deposits held at an FDIC-insured bank and is subject to applicable limits and ownership-category rules. It does not protect against inflation, taxes, liquidity constraints, or reinvestment risk. Investors should review a CD’s terms, confirm applicable deposit-insurance coverage, and consult their financial and tax professionals before making a financial decision.