How Does Inflation Affect Your Savings?

Many financial experts recommend that you take 10% of your income and deposit it into a savings account. However, the majority of people never know how much they are actually saving. For example, when you deposit the money into your savings account, a dollar buys a loaf of bread, but by the time you withdraw that money, a loaf of bread costs $1.29. This is inflation at work. While you may have received some interest in your savings account, the question is, does it make up for the inflation?

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Inflation is Your Enemy

Most people don’t think about or even understand inflation. They simply follow the rules of good money practice by saving and not over-spending. The above illustration showed that you had saved 10% of your income, which is typical of the advice that you will hear growing up. What they don’t tell you is that inflation will eat into your savings. Prices rise over time, wiping out your buying power.

Unfortunately, many people put their money into a savings account that pays a standard interest rate. For example, if you deposit $1,000 in a savings account that pays a 1% interest rate, after a year, you will have $1,010 in your account. Over the same time, if inflation is running at 2%, which, by the way, is the goal of the Federal Reserve, you would need to have a balance of $1,020 to make up for the impact of higher pricing. Since you only have $1,010 in your account, you have actually lost some purchasing power. If your savings don’t grow to reflect the rise of pricing over time, it’s the same as losing money.

You Should Still Save

Because of inflation, saving isn’t as simple as putting money into a savings account. True, you should have some money in a savings account, typically a six-month supply in case of loss of employment or some type of illness. Beyond that, you should then start to look at ways to outpace inflation. Some people do it in a 401(k), while others will do it in an investment account. The whole idea of a 401(k) or retirement account is to outpace inflation over the longer-term. This is why the stock market is a better option than a savings account since, historically, it returns 8% a year. However, that is in the long term, and fluctuations do happen along the way. You also have to pay capital gains tax, which is beyond the scope of this article, but this will also have an effect on how much you can actually pull out of your account. There are a multitude of ways to work around this though.

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Multi-tiered Approach

If you wish to beat inflation, and that should be your number one goal, you simply must have a multi-tiered approach to savings. Savings should be thought of as not only cash in the bank, but also investment vehicles. The average financial advisor will suggest stocks, bonds, CDs, real estate, and even a small amount of precious metals, to protect from a falling dollar. By spreading around your savings, you allow for diversification, one of the greatest ways to protect yourself from asset depreciation. For example, if inflation runs at 3% next year, your savings account offering 1% in interest isn’t going to cut it. However, the real estate market might be heating up, and if you own real estate, you may find that you make 10% on your rental property or your home.

This is how savings should work; it should be a mix of cash on hand and investments. If you do not invest, you are sure to have less purchasing power down the road. In fact, most people don’t understand this but when measured in purchasing power, the US dollar has lost almost 98% of its value since 1913!

 

It Can Be Done

Outpacing inflation isn’t difficult, but it takes a bit of thought. You need to find ways to lower your tax burden, higher interest rates or returns, and the like. While it is necessary to have that emergency cash fund, once you get passed that threshold, you should start looking for ways to make your money work for you. Investing and saving are essentially the same thing, at least in the modern financial world. If your employer has a program that matches your 401(k) contributions, by all means you should max out what you put into it. That is essentially free money for retirement.

Beyond that, start looking for assets that will pay you to own them. Rental properties are a great way to save for retirement. Not only do you have someone else paying for the property through monthly rental payments, but you can also sell the property one day and earn on the sale. Stock market investing is good for the long term, but obviously carries its own risks. The whole idea is you need to start thinking beyond simply stashing cash somewhere and ensure you stay one step ahead of inflation.