Your coffee break investment plan - Day 4: The two enemies of investors: Inflation and tax

Inflation and tax are the two most hated enemies of investors. This dastardly duo has the ability to significantly reduce the value of your investment, although the good news is that some clever financial planning can reduce their power.

Let’s take each in turn. Inflation charts how the prices of goods and services increase over time. So, if your investments double in value over 10 years but the cost of living goes up by a similar amount then you’re no better off.

More worrying is if your investments lag inflation because this means the real value of your money will reduce over time and can leave you with a shortfall.

Justin Modray, founder of Candid Financial Advice, says: “Suppose you have £10,000 in a savings account paying 1.5% interest that you want to leave for a year before using to buy a car. Ignoring tax, this would be worth £10,150 after a year but if inflation is higher and pushes the car price to £10,300 you’d have to find an extra £150.”

At the very least, therefore, your objective should be for savings and investments to keep pace with inflation. “Inflation is calculated using the prices of many day to day items and services, but this simple example highlights the risks of lagging inflation,” he adds.

The effect of inflation on the value of £100

Number of years 2% inflation 3% inflation
Day 1 real value £100 £100
1 year £98.04 £97.09
5 years £90.57 £86.26
10 years £82.03 £74.41
20 years £67.30 £55.37
30 years £55.21 £41.20
40 years £45.29 £30.66
Source: Chase de Vere

The impact of inflation eroding the value of savings has been endured by cash savers in the era of low interest rates over the past seven years, points out Patrick Connolly, a certified financial planner with Chase de Vere.

“Since then the returns from most savings accounts have been lower than the rate of inflation, meaning the real value of people’s savings has fallen,” he explains. “With little sign of an increase in cash savings rates, many people will continue to lose money in real terms.”

Moneywise can help you get the best rates on your savings.

But Mr Connolly suggests the best way to beat inflation in the long term is to hold a diversified investment portfolio of shares, fixed interest and property.

How to beat tax

You don’t have to be a millionaire to start protecting your money from the taxman. With just a little effort you shouldn’t have to pay very much tax on your investments at all.

For example, under individual savings account (Isa) rules you can invest up to £15,240-a-year in either a cash Isa or a stocks and shares Isa. With cash Isas you don’t pay tax on saving accounts interest, while with stocks and shares Isas there’s no tax to pay on income or capital gains.

Mr Connolly says: “You should aim to use your various allowances, such as Isas, pension contributions, capital gains tax annual exemption and the upcoming tax-free allowance for savings interest.”

Pensions are complicated but for longer-term requirements they are hard to beat due to the tax reliefs on the way in, the tax-free growth, and the fact you can take a 25% tax-free lump sum on retirement, says Tom McPhail, head of pensions research at Hargreaves Lansdown.

“If you are an employee you get the additional benefit of an employer contribution as well as your Government tax relief top up which means for every £1 you invest you can end up with £2 in your pot,” he says. “For most people a pension will be the core of their retirement saving.”

If you missed them last week, make sure you read the first articles in this series.

Day 1: What is investing?

Day 2: What is the stock market?

Day 3: Setting investment goals

Also watch Moneywise editor Moira O’Neill interview Andy Parsons from The Share Centre about why you should start investing.

Coming tomorrow:

Day 5: The importance of keeping charges low

Your Comments

Have to dispute Patrick Connolly's claim - or the impression given - that most high-street savers' returns over the last seven years have been lower than the rate of inflation.  With inflation running at less than 0.5% on average over the last two years (source: my Civil Service Pension) anyone who hasn't been able to beat inflation handsomely has been either very unlucky or very lazy. 

Over the last seven years, inflation has been eating into savings accounts, averaging 2.3%. In 2011 it was above 4% throughout the year.

RHT is right that savings accounts have beaten inflation over the last year, but that's down to an unusually low period of inflation, largely due to falling oil prices.

It looks like that period is now over, and inflation is rising again. It's gone up four times in the last five months.