Smart Women Smart Money | Harris & Harris Wealth Management

I was recently reading a report entitled A Study of Real Real Returns from Thornburg Investment Management. It caught my attention because it discussed some key factors I want to share with you. They affect your return on your investments. Let’s start by discussing a major part of most American’s retirement, your 401K. If your 401K is earning an average rate of return of 7%, that is what is called nominal rate of return. However, practically speaking, it is not what you will actually see when you start using it during retirement, it is not your real return. Let’s look at what that means to you.

There are three factors that strongly affect the difference between the reported rate of return (What you see on your account statement) and your actual rate. They are: 1) Inflation, 2) Taxes, and 3) Investment Expense.

1) We all know what inflation is: It’s the rate at which prices for goods and services increase over time. More simply, it’s why prices keep going up, why a new fashion forward outfit with matching stilettos costs more now than it did last year. If you remember the mid-70s, you remember 12% inflation, which seriously affected the household budgets of the average family. We’re at a modest 3% now. So you may ask, ”What does this mean in terms of my portfolio return?” It’s simple. Inflation erodes your return. If your investments were earning only a 3% return, your buying power wouldn’t be increasing at all because you’d just be keeping up with inflation. If you earn 7% and subtract 3% to cover inflation, you end up with a “real” return of 4%. That is, the buying power is beating inflation by 4%.

2) Now let’s go on to the matter of taxes. You are taxed on three types of income: ordinary income (what you earn, your paycheck, your W-2s), dividend income, and capital gains. Dividend income comes from a company sharing its earnings with stock owners while capital gain is from increased value of an asset, such as a home, bond, and of course, a stock. You do not receive capital gains until you sell an asset. To receive the current 15% rate for capital gains, you need to have owned the asset, such as a stock, more than a year. I know taxes are such a controversial subject. Especially during an election year. Especially this election year! But I will approach it delicately, and from the investor’s prospective.

The IRS will tax your income and that includes investment income. For example, income that comes from interest on corporate and U.S. government bonds is added to your overall income and taxed at whatever bracket you fall into. The range is 10% – 35% these days. So the specific amount you keep is based on your tax rate. Just note, municipal bond interest is generally not subject to ordinary income taxes, federal or state.

When you earn dividend income from stocks, under the current tax laws you pay only 15%. Since the current legislature is set to expire soon, this rate could change. So investment income taxes are yet to be determined past 2012. How investment income is classified for taxes, impact your “real” return.

Lastly, investment expenses are what you pay to own that portfolio of stocks, bonds, real estate, and commodities. These amounts may range from 0.50% – 2% of your portfolio value. (For real estate, your fee may be up to 6%.) With the exception of real estate, an increase in your portfolio value means a decrease in the fees your advisor charges you. So, this is not a tax per se, but it is a factor that affects your “real” return. Maintenance costs and commissions greatly affect the cost of owning real estate, and reduces its overall return.

When an investment analysis of your portfolio is presented to you it should take into account all these factors so you have a clear picture of whether you are on track to achieving your goals in style.