I Bond return after taxes

[mark]

If I am figuring this correctly, unless the fixed rate of an I Bond is at least 3% (the percent that is added to the inflation rate), then one's investment loses purchasing power, after taxes are factored in.

Consider:

$1000 I Bond
Inflation: 5%
I Bond Fixed Rate 1.2%

Value after one year: $1062 (1000 X 6.2%)
Value after one year after taxes subtracted (33% tax bracket) =
$1062 - $20.6 = $1041

Thus your investment is worth $1041 after taxes, but to keep even with inflation, your investment would have to be $1050.

 

[Cut-Throat]

Not doubting your numbers at all. - That's why they say "with fixed return investments you are guaranteed to lose money"

- Which might be fine when you are 80 years old. - You at least know where you stand, and won't be standing long

 

[wabmester]

Well, everybody is in a different tax situation, but taxes on i-bonds are deferred, so if you're in a high bracket now, you might not be in that same bracket when you cash them in. And 33% is the max *marginal* rate, so most of your income is not taxed at that rate even if you're in that bracket (and of course, you know that i-bonds are free of state tax).

Finally, most of us here just budget taxes as yet another expense. And given what stocks have returned in the last year, you could lose money to the market, lose money to inflation, and lose money to the tax man.

 

[Gone4Good]

Tis true.  I Bonds, TIPs, etc. protect you against inflation in a perfect world that does not include taxes.

Consider the nightmare of the poor investor who buys $2 MM in TIPs, thinking he/she is going to live off of the real 2% return ($40K / year).  Assuming 3% inflation our poor investor will receive $40 K in interest payments but will pay taxes on $100,000 ($2MM * [2% + 3%]).  For a single filer using the standard deductions they would owe roughly $16 K in taxes, leaving them just $24,000 to live on.  

For higher rates of inflation the tax bite is greater.  

 

[retire@40]

If I am figuring this correctly, unless the fixed rate of an I Bond is at least 3% (the percent that is added to the inflation rate), then one's investment loses purchasing power, after taxes are factored in.

Consider:

$1000 I Bond
Inflation: 5%
I Bond Fixed Rate 1.2%

Value after one year: $1062   (1000 X 6.2%)
Value after one year after taxes subtracted (33% tax bracket) =
$1062 -  $20.6 =  $1041

Thus your investment is worth $1041 after taxes, but to keep even with inflation, your investment would have to be $1050.

This would pertain to any investment earning 6.2%, not just bonds.

To keep up with inflation, just plug in your numbers to solve for one unknown:

Interest Rate - (Interest Rate * Tax Rate) = Inflation Rate

In your case the interest rate you would need is 7.47% just to keep pace with inflation.

The SWR is 4%, so you would need about 11.47% total return to keep you happy.

However, most ER types are not in the 33% bracket, more like 10% average.
Second, inflation tends to be lower than 5%, more like 3%.

So for the average ER to keep pace with inflation, he needs 3.33%.

Tack on 4% for the SWR and the total rate needed is in the 7.33% range.

 

[wabmester]

Good point, ...Years.   In your example, if your living expenses ex-taxes are $40,000, then you should add $16K to those expense for taxes, making your withdrawal rate an incredible 2.8%.   Which would last you a VERY long time.

Don't forget kids, if you plan to live 30 years, then you can withdraw 3.33% (100%/30, not inflation adjusted) each year even if you just stuff the money under your martress.  

 

[Gone4Good]

Don't forget kids, if you plan to live 30 years, then you can withdraw 3.33% (100%/30, not inflation adjusted) each year even if you just stuff the money under your martress.  

And on the 31st year they fasted

 

[GTM]

If I am figuring this correctly, unless the fixed rate of an I Bond is at least 3% (the percent that is added to the inflation rate), then one's investment loses purchasing power, after taxes are factored in.

Consider:

$1000 I Bond
Inflation: 5%
I Bond Fixed Rate 1.2%

Value after one year: $1062   (1000 X 6.2%)
Value after one year after taxes subtracted (33% tax bracket) =
$1062 -  $20.6 =  $1041

Thus your investment is worth $1041 after taxes, but to keep even with inflation, your investment would have to be $1050.

The idea of the I bond is the amount added to the fixed rate is the same as the inflation rate.
Maybe that is not always the case I am not sure how accurate the formulas used are but if it is accurate your real return would be the fixed rate.

Income tax is due on gains of stock and variable instruments as well as fixed rates.

 

[sgeeeee]

. . .Don't forget kids, if you plan to live 30 years, then you can withdraw 3.33% (100%/30, not inflation adjusted) each year even if you just stuff the money under your martress.  

Someone should tell hosuc and JWR about this "matress" investment plan.  They have the safe withdrawal rate at about 2% now.

 

[Ol_Rancher]

Good point, ...Years.   In your example, if your living expenses ex-taxes are $40,000, then you should add $16K to those expense for taxes, making your withdrawal rate an incredible 2.8%.   Which would last you a VERY long time.

Don't forget kids, if you plan to live 30 years, then you can withdraw 3.33% (100%/30, not inflation adjusted) each year even if you just stuff the money under your martress.  

I hope you don't mean 'mistress', otherwise the plan would never work. If you mean 'matress' be sure you have no mistress on that matress.

 

[cute fuzzy bunny]

The idea of the I bond is the amount added to the fixed rate is the same as the inflation rate.
Maybe that is not always the case I am not sure how accurate the formulas used are but if it is accurate your real return would be the fixed rate.

Some day I'll get tired of saying this, I promise.

The amount added to the fixed rate is the CPI rate, which is not necessarily the rate of inflation, which is not necessarily the rate of personal inflation.

It is only a 'real return' if your personal rate of inflation is equal to the CPI minus taxes.

I got off on this jihad after listening to too many inexperienced investors (two of whom were named a little ways up and will remain nameless by me because they're hosuc and JWR) who thought they could buy an x% ibond or tips and spend that x% as it would be a true inflation proof 'real' return. They then compounded the error by then determining how long they'd live and eating their principal by 1/expected life span.

Smart guys that believe that CPI = personal inflation rate and knowing how long they're going to live...

 

[mark]

Ah, "web" has a point. The tax rate used to determine your after tax rate of return should be the effective tax rate, not the marginal rate. That makes I Bonds a little better:

$1000 I Bond with a CPI rate of 1.2%
Inflation Rate 5%
Marginal Tax rate: 28%
Effective tax rate: 20.21% http://www.dinkytown.net/java/TaxMargin.html


After one year, your Bond is worth $1062. The 62$ interest is taxed at the rate of 20.2% for an after tax return of $49.
To buy $1000 of goods after one year with an inflation rate of 5%, you would need $1050. Your total amount from the I bond is $1049. So your money did not grow, but you pretty much kept up with inflation.

It seems that the important variables are the CPI rate of the I bond, and your individual effective tax rate when you redeem the bond.

 

[wabmester]

That's the reason I choose TIPS over i-bonds. The fixed "real" portion is higher. My personal rule of thumb is to ignore TIPS/i-bonds unless the fixed rate is 2.5% or higher. 2.5% is the average real return of treasury bonds over the last 50 years, so that's what I use as a benchmark.

Back when TIPS had a real rate of 4%, that was the bargain of the century. 4% is pretty close to the historical real return of stocks, so you could get stock-like returns with essentially zero risk.

 

[Michael]

Taxing the inflation adjust portion of TIPS and Ibonds is an example of how our government punishes savers. They are by definition taxing something that is not even a gain. It is no wonder that the national savings rate is zero. I guess they think it is better for the economy if most workers spend every last dime, instead of saving something for their future.

 

[wabmester]

I guess they think it is better for the economy if most workers spend every last dime, instead of saving something for their future.

It's the "ownership society" thing.   They cut taxes on dividends and cap gains, gave us a negative real return on savings, and taxed interest at high rates.   Yeah, we get the message.  They want asset bubbles, I guess.

In any case, I don't know about you, but I'm retired.   I have dependents.   And I have a mortgage.   This means that I can have a relatively high bond income and still end up with an effective tax rate at around 5%.   I don't sweat the taxes.

 

[Michael]

They cut taxes on dividends and cap gains...

Keep going. Eliminate all taxes on capital gains and dividends. As Alan G. testified to Congress, it is an extraordinarily inefficient way to raise taxes. Congress is consuming its seed corn by taxing them. Even so, taxing the portion of interest that just keeps up with the CPI penalizes and discourages saving. The same for keeping short interest rates below the CPI.

 

[Gone4Good]

Taxing the inflation adjust portion of TIPS and Ibonds is an example of how our government punishes savers. 

Other "capital gains" (stocks, investment real estate, Nords 'wheat penny', etc) aren't adjusted for inflation either, so you have the same problem with them.

As far as interest on debt, corporations get the interest write-off - you get the taxes. Treasuries aren't taxed at the state level and some muni's aren't taxed by anyone.

Dividends are taxed as corporate income and as investment income. Same thing with capital gains which are typically the result of already taxed retained earnings.

All-in-all, though, the current tax structure seems to favor investment income over earned income.

 

[Michael]

All-in-all, though, the current tax structure...

Go back to olden times. 10% tax on increase, and not a penny more.