Building wealth can be quite a challenge. On one side, there’s the obligation to pay taxes on your earnings. On the other, inflation relentlessly erodes your savings. With these two formidable forces in play, you might wonder whether it’s even worth trying.
Taxes and inflation are closely intertwined. Both are government-induced phenomena. Taxes are explicit and often resented, while inflation operates quietly, but its effects can be insidious.
“Inflation is always and everywhere a monetary phenomenon,” stated Milton Friedman. Essentially, he implied that inflation stems from an increase in the money supply compared to the supply and demand for goods and services. It’s important to note that rising prices themselves aren’t inflation; they are merely a byproduct of an expanded monetary base.
Inflation, which reflects an increased money supply, is a government-driven process. It enables governments to fund expenditures they otherwise could not afford through direct taxation.
John Maynard Keynes articulated this succinctly: “By a continuing process of inflation, governments can secretly and unobservedly confiscate an important part of the wealth of their citizens.”
While inflation has been a constant over the past century, periods of deflation have also occurred. For instance, in mid-2008, inflation surged as oil prices skyrocketed to $147 a barrel. By early 2009, however, deflation set in, causing a dramatic drop in oil prices to below $40 a barrel. Subsequently, oil prices climbed back over $110 before recently settling around $95.
Such sharp fluctuations highlight the challenges of investing in an inflationary climate. Maintaining cash reserves to weather these deflationary storms is essential, but this raises a related issue…
How can you hold cash without succumbing to the ravages of inflation?
Today’s guest essay from Terry Coxon, Contributing Editor at Casey Research, aims to address this important question.
Enjoy,
MN Gordon
Economic Prism
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Three Strategies to Protect Your Cash from Inflation
The anticipated high inflation rate poses a formidable challenge for investment markets. Identifying potential winners—such as gold, silver, and stocks of precious metals—as well as likely losers—like long-term bonds and many stocks—is relatively straightforward. However, achieving financial success in a scenario marked by rapidly rising consumer prices requires more than making these distinctions.
Heightened inflation rates will introduce increased volatility across all financial markets. The more you anticipate inflation and the rise of gold, the greater the asset volatility you should expect. Even if the dollar is indeed heading toward a downfall, the journey may involve numerous detours and regressions.
Inflation is not a smooth process; it disrupts both the economy and the political landscape. Over the next five to ten years, it’s likely that the Federal Reserve will view inflation as a pressing concern. Each time this occurs, the Fed may slow or halt the creation of new dollars altogether.
These temporary pauses in monetary expansion won’t last long, but during that time, they will adversely impact most investment markets, including the gold market and the stocks of companies that either produce or search for it. You could be accurate in your long-term outlook for the dollar yet still face a turbulent ride.
The events of 2008 serve as a preview of the market turbulence you may soon face. Future downturns are likely to be even more severe, and you do not want to be among the hard-money investors who become overwhelmed. To safeguard against this, maintaining cash as a constant and essential component of your portfolio is crucial. A healthy cash reserve can bolster your confidence during turbulent times, making it easier to hold on to other investments when they face market pressure. Additionally, cash provides an opportunity to buy during dips and significant downturns.
The Dilemma of Cash Value
Of course, cash itself will continue to lose value over time. However, the extent to which your cash’s purchasing power diminishes will largely depend on how you manage it.
Typically, interest rates on money market instruments, like Treasury bills and large certificates of deposit (CDs), move in tandem with the inflation rate. The Federal Reserve may attempt to keep rates on money market instruments slightly below the inflation rate, but this tactic is only sustainable for a limited time. Efforts to suppress short-term interest rates often lead to higher inflation later. Conversely, the Fed can keep money market rates above inflation for a while, but this will likely slow inflation in the long run. Ultimately, money market instruments’ average yield generally aligns with the average inflation rate.
Given this relationship, holding cash doesn’t appear to be terribly painful. The decline in purchasing power may be offset by the yield. However, this comforting thought must be tempered with the reality of taxes. Although the yield compensates for lost purchasing power, it is still subject to income tax unless mitigated in some way.
For those who choose to ignore this tax implication, they may unknowingly expose their portfolio to risk. For instance, if inflation hits 10 percent and money market yields hover around that level, anyone in a 40 percent tax bracket could see their cash lose purchasing power at a rate of 4 percent annually. This situation can worsen with rising inflation, tempting you to reduce your cash holdings to mitigate the erosion. However, such actions would render you ill-prepared for the next significant market downturn.
To maintain cash holdings while mitigating shrinkage, consider tax-advantaged environments that protect yields. Let’s explore some options—some of which might not be to your liking.
Deferred Annuities
A straightforward annuity is a contract with an insurance company that guarantees annual payments for life. A deferred annuity, however, begins with an accumulation period where the contract earns interest or other returns. You can end this phase at your discretion, either receiving lifelong payments or simply withdrawing the accumulated value.
Earnings within a deferred annuity enjoy tax-deferred growth until withdrawn. If the returns match money market yields, the real value of the annuity may remain stable even during high inflation.
Though deferred annuities have fallen out of favor, their relevance resurfaced notably during the high-inflation years of the 1970s and 1980s. Back then, exorbitantly high interest rates made them attractive. More recently, however, low interest rates have diminished the appeal of tax-deferred compounding. It’s during high inflation periods that the benefits of such compounding truly shine.
When inflation heats up, leading to soaring money market rates, expect to see a resurgence in advertisements for deferred annuities. While they can offer better value than cash in a bank account, annuities do have some drawbacks.
The first concern is that the tax benefits of avoiding taxation on nominal returns eventually end. Even if your annuity’s value holds steady against inflation, the eventual cash-out will trigger taxes on accumulated interest, significantly eroding your purchasing power. After a decade of high inflation, if you’re in a 40 percent tax bracket, much of what you withdraw will likely be taxable interest, resulting in a considerable one-time loss of your purchasing power.
The second limitation is that, to my knowledge, insurance companies do not currently provide options allowing you to shift your annuity’s value between monetary investments and those linked to precious metals. However, this could change as inflation rises and interest in gold increases. Until then, no tax-efficient method exists to utilize the purchasing power protected by your annuity for gold investments during adverse market conditions.
Cash Value Life Insurance
Like deferred annuities, earnings on cash value life insurance policies can also grow and compound without being subject to current taxation. But that’s where the similarities halt.
Unlike deferred annuities, the earnings from cash value life insurance can be extracted tax-free. The most straightforward method is, of course, for you to pass away. An alternative route entails borrowing against the policy, which can also be done tax-free if the policy adheres to the “7-pay” rule, in which premiums are equalized over seven years.
The ability to borrow against the policy without incurring tax liabilities would allow you to access its value whenever hard investments, like gold, experience significant downturns. This flexibility is indeed beneficial, although it might not come without costs depending on your unique situation.
Due to the Internal Revenue Code’s stipulations and various states’ consumer protection rules, it’s impossible to obtain a life insurance policy in the U.S. without a face value that significantly exceeds your investment in the policy. This discrepancy accounts for the insurance company’s mortality risk—the chance that you may not live to fulfill the contract. Naturally, this risk incurs associated costs, typically around 1 percent annually based on the capital you wish to secure within the policy.
Whether a cash value policy (specifically a 7-pay policy) is a wise option for protecting cash against inflation depends on your individual circumstances. If you need pure life insurance coverage, opting for a cash value policy can make sense, especially if it is invested in money market instruments to prepare for inflation. However, if you have no ongoing need for life insurance, using a cash value policy for tax advantages may lead you to unwittingly gamble on your longevity, which many may find unappealing.
Retirement Accounts
If available, the most effective approach to holding cash during inflationary periods is through an Individual Retirement Account (IRA). You can invest in T-bills, insured jumbo CDs, and other money market instruments without any of the associated costs of a deferred annuity or life insurance policy. This arrangement is also protected from current taxes, and with a Roth IRA, the proceeds can eventually be withdrawn tax-free.
A solo 401(k) offers similar benefits, and if your employer sponsors a 401(k), you may have similar opportunities based on the plan’s investment options.
While retirement plans provide the ideal solution, there are limitations regarding their size. Unlike deferred annuities or cash value life insurance, IRAs have stricter scalability. If you want to transfer a portion of your non-IRA assets into a traditional IRA, you can make adjustments as follows.
Examine your traditional IRA closely. How much of it is genuinely accumulating tax-deferred wealth? The reality might be less than you think.
For instance, if you’re in a 40 percent tax bracket, when it comes time to make withdrawals, you will lose 40 percent to taxes. Your ability to defer doesn’t change this outcome. Essentially, you now own only 60 percent of your traditional IRA’s assets. If your IRA has $100,000, only $60,000 is genuinely working for you.
Thankfully, there’s a remedy to reclaim the government’s share: a Roth conversion. You pay the taxes upfront, allowing your future withdrawals to be tax-free. This strategy effectively reduces the assets you directly control by $40,000 (the cost of the tax on the conversion), while simultaneously increasing the amount within the IRA doing the work solely for you by $40,000.
This strategy represents a significant improvement because it shifts your money away from a taxable environment into one where all earnings can be reinvested. In practical terms, the effective size of your IRA can increase by two-thirds, meaning significantly more capital is available for tax-free compounding.
You can implement a similar approach with a solo 401(k) plan by taking advantage of Roth conversions.
The financial rationale behind a Roth conversion is compelling, especially if you first restructure your IRA into an Open Opportunity IRA. This structure emphasizes greater investment freedom, allowing more flexibility.
Rather than being limited to the investments permitted by your current IRA custodian, your IRA would own a limited liability company that you manage. You could then transfer your existing IRA investments into this new LLC structure, allowing you to shift into real estate, gold, equipment leasing, or other opportunities.
This flexibility, coupled with potential savings on Roth conversion costs through a well-designed LLC, can provide significant advantages.
Time to Strategize
Deferred annuities, cash value life insurance, and retirement accounts are effective tools for safeguarding the purchasing power of cash needed for portfolio stability during periods of rapid inflation. These options can effectively reinvest money market yields, which usually track inflation rates, without incurring current taxes.
These three alternatives are not mutually exclusive; combining them may yield optimal results. The best choice depends not only on their inherent characteristics but also on your personal circumstances. Now, before Consumer Price Index (CPI) inflation grabs headlines, it’s a prudent time to weigh your strategic options. Even if you’re hesitant about these choices, any of them will outperform letting your cash lose value.
Sincerely,
Terry Coxon
for Economic Prism
[Editor’s Note: Contributing Editor Terry Coxon is president of Passport Financial, Inc., and for over 30 years, he has advised clients on legal methods to internationalize their assets for optimal tax, wealth protection, and estate planning goals. Discover more strategies for wealth protection in The Casey Report.
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