The money individuals save today will buy less in the future. The cup of coffee that cost $1.00 at one point in time, costs $5.00 today. Inflation compounds over time. It’s a hard truth every earner encounters. In 2022, inflation hit a 40-year high, and consumer prices rose 8.5%, according to the U.S. Bureau of Labor and Statistics. [1] An underfunded retirement savings can jeopardize financial security in the later stages of life. A financial advisor can help investors understand the impact of inflation on retirement income and implement strategies to mitigate it.
Understanding Inflation’s Effect on Retirement Income
Prices double approximately every 24 years with an average annual inflation rate of 3%. This can make living on a fixed income especially difficult. For example, if a retiree needs $50,000 per year to cover expenses today, in 24 years, the same lifestyle will cost a retiree $100,000. While Social Security recognizes inflation by applying a cost-of-living adjustment (COLA), relying on Social Security benefits is insufficient for living comfortably with inflation in retirement. Personal savings and investments supplement Social Security benefits. Ideally, those also account for inflation. People planning for retirement should assume an annual inflation rate of 3%, but discussing inflation with a wealth advisor is worthwhile.
Tax Implications of Inflation
Savers should be aware of the tax ramifications of inflation. Income tax brackets are indexed for inflation, however, the $3,000 limit on capital loss deductions has remained the same since 1978. This deduction is worth less today than it once was. Similarly, capital gains face multiple layers of tax, and gains are not adjusted for inflation. Finally, a Net Investment Income tax (NIIT) of 3.8% applies to individuals, estates, and trusts that have adjusted gross income above certain thresholds that are not indexed for inflation. [2]
Up to 85% of Social Security benefits are taxable for individuals with a combined income of more than $34,000 and married couples filing jointly with a combined income of more than $44,000. These income thresholds have not changed since they were first instituted in 1984. Therefore, the proportion of beneficiaries who pay income tax on their benefits has grown with increased wages over time. [3] Social Security benefits do have a COLA however, the majority of beneficiaries now pay taxes on them, which counteracts the adjustment. Also, the COLA may not be enough to cover inflation plus the rising cost of essentials. To this end, a 2019 Senior Citizens League study revealed that Social Security benefits have lost 33% of their buying power since 2000. [4]
Strategies for Mitigating the Impact of Inflation
There isn’t anything a person can do to stop inflation, but there are measures individuals can take to reduce its impact on a hard-earned nest egg. Here are a few:
- Diversify the investment portfolio—Having a varied portfolio that includes different types of accounts and assets including stocks, bonds, real estate, etc., can combat the effects of inflation. For example, stocks usually offer higher returns than bonds and savings accounts. Bonds increase in value with inflation. They can safeguard against inflation in that way, especially Treasury Inflation-Protected Securities (TIPS).
- Invest in real estate—Not only can real estate generate rental income, but it can also appreciate over time. Real estate often keeps pace with or exceeds inflation rates, although rental income moves with it. Real estate investment trusts (REITs) are another inflation-friendly investment option for those not interested in managing properties. REITS are company-owned, operated, or financed income-generating properties. A pool of capital investors earns dividends from the properties. Unlike real estate investments, most REITs are publicly traded like stocks. [5]
- Transfer savings to a Roth IRA—Roth IRA contributions are made with after-tax dollars. This means taxes will not be applied to withdrawals later in retirement. [6]
- Increase savings and start early—Saving a greater income percentage can counter inflation. The 4% retirement withdrawal strategy suggests that retirees can safely withdraw up to 4% of their savings within the first year of retirement, adjusting for inflation in subsequent years. This may not work in times of high inflation. Savors should still aim to save as much as possible.
The benefits of an inflation-adjusted financial plan include maintaining a comfortable standard of living throughout retirement, reducing longevity risk, having flexibility to handle emergencies, and instilling peace of mind about the future. SHP Financial is here to help clients design and maintain a strong portfolio that weathers the effects of inflation. Regular portfolio evaluations with a wealth advisor ensure that the lifestyle you saved for lasts throughout retirement. Click HERE to connect with a wealth advisor for a complimentary review of your finances today.
Sources:
[1] https://www.cbsnews.com/news/inflation-cpi-consumer-price-index-highest-40-years/
[2] https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax
[4] https://seniorsleague.org/loss-of-buying-power-2/#:~:text=
[5] https://www.investopedia.com/terms/r/reit.asp
[6]https://www.investopedia.com/articles/retirement/052616/how-inflation-eats-away-your-retirement.asp
