Inflation In Bank Accounts

Let’s pretend you have saved $100,000 on Dec 31st 2007. You want to put it in a term deposit bank account to earn some interest. You find a one year term deposit that is paying 5%. Wow you think, I can earn $5000 just by leaving my money to sit.

Are you really earning $5000 on your money? Yes, in real terms you are, however you must take inflation into account. As we know, in 2008 inflation was running at 3.7%. This means that your purchasing power has gone down by 3.7%. Meaning that if a bag of shopping cost you $100 on Dec 31st 2007 it would have cost you $103.70 on Dec 31st 2008.

So let’s look at this as a maths figure

Jan 1st 2008 $100,000 in a term deposit at 5.0% interest
Dec 31st 2008 $105,000 in a term deposit
But in purchasing power we need to subtract 3.7% from the total figure to give us an amount of $101,115.

To make this scenario easy to understand the following statement is true, “While you have $105,000 in real money it could only purchase what $101,115 could have on Dec 31st 2007. To put it frankly, you have only grown your purchasing power by $1115 at Dec 31st 2007 prices.”

And guess what this does not even take into account taxes that you have to pay on the interest.

Let’s say for example this person that has saved $100,000 currently, at a job where they earn $50,000 a year before tax. The government no longer taxes them at $50,000 a year. The government now charges them as if they had earned $55,000. They consider the interest of $5000 part of their wage.

Wow, your purchasing power has been eaten into again as the goverment will want to tax you more!

I have quoted from one of Warren Buffet’s (the world 2nd richest man) sayings. Please note I had to read this saying quite a few times before it stuck, however it does make extreme sense:

“It makes no difference to a widow with her savings in 5% passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% of inflation. Either way, she is taxed in a manner that leaves her no real income whatsoever”.