One of the most important things you can do when it comes to building wealth is to understand how your money is working for you. Having an idea of the factors that negatively impact your savings and investments will help to limit the damage to your wealth, too. Three wealth destroyers to be aware of are taxes, inflation, and fees. Here’s how they can affect your wealth.
Taxes
Taxes are one of the biggest destroyers of wealth there is and are essentially a shackle on our assets. When you pay taxes, you’re providing the government with money you could have used to earn interest and increase your own wealth. There are three options when it comes to tax liability.
1. Reducing your tax liability – While not everyone has the ability to reduce their tax liability right away, it should be your ultimate goal. Luckily, there are a number of strategies you can apply that will help you achieve it.
2. Deferring your tax liability – Investing money in retirement accounts like a 401(k) or Roth IRA allows you to put untaxed money away to grow your retirement funds. However, that doesn’t mean your money remains untaxed. Rather, you will be taxed once the money is withdrawn. In short, not only are you deferring the tax payment but also the tax calculation.
Deferring your tax liability is like having a rich uncle who writes you a check and tells you not to worry about the repayment terms until sometime in the future. At that time, he’ll tell you the terms and the repayment amount. Would you cash that check?
3. Paying taxes upfront – If your only plan for retirement is to utilize deferred accounts, when it comes time to retire you will likely be in a much higher tax bracket. A higher tax bracket can result in your Social Security being taxed and you may be required to pay an excise tax on Medicare premiums. By paying taxes today, you free yourself up to invest in an option that will give you a tax-free payout down the road and avoid any future increases in the tax rate.
Inflation
According to the Federal Reserve, in order for the economy to be stimulated, prices need to slowly increase. The fact of the matter is inflation increases the cost of the goods and services we use every day, resulting in us having to work harder and longer to pay for them.
The truth is, the value of $100 will not be the same in 100 years as it is today. Just like the value of a dollar is not the same as it was 100 years ago. Remember when you were a kid and could buy a single Tootsie Roll for a penny? Today, that same Tootsie Roll costs more. As inflation increases, our money loses value.
Though prices generally increase by a barely noticeable percentage each year, over time they add up to big increases. Look at it this way; with a 3% annual inflation rate over the course of 25 years, a dollar’s value shrinks to about $0.48. That’s less than half of its original value! With such an impact on the value of a dollar, it’s easy to see why inflation is one of the three wealth destroyers. In order to beat inflation and ensure your investments will keep up, you need to learn the proper strategies.
Fees
From overdraft fees to monthly service fees, banks and other financial institutions chip away at your wealth as a means to finance their own business. When you deposit money into your bank account, you’re providing the bank with the funds to create loans. But, banks aren’t the only ones using fees to limit your wealth. In truth, financial products are not free.
Most financial service providers charge small fees and commissions to handle your money, too. While they may seem like minor fees up front, they can have a big impact on your wealth over time. For example, when it comes to investing money, fees hit investors hard with a one-two punch. First, as your account balance grows, so do your fees which are calculated based on a percentage of the total value of your investment portfolio. The second punch causes even more damage to your investment portfolio’s returns. Every dollar taken from your portfolio to pay a fee results in one less dollar that can compound and grow.
So, while most people thinking fees aren’t that big of a deal, they add up over time. Even a small 1% fee you pay for your 401(k) can end up being much larger than the match you receive from your company. Sure, your employer’s match may have been good for someone, but that someone may not end up being you.
Having an understanding of how your money is being used will go a long way in protecting your wealth. Knowing what kind of fees you’re being charged to “grow” your wealth will give you a big picture view on how it affects your money over time. Once you’re aware of how fees can destroy your wealth, you’ll be able to make better decisions when it comes to how you manage and invest your money.