Inflation and Taxation: What Clients Need to Know

Editor’s note: Lewis Walker is a columnist for Rethinking65. Read more of his columns here.

The presidential election of 2024 was about many things, but consumer and breadwinner dissatisfaction regarding inflation and a rising cost of living were major factors. Your clients are likely thinking about inflation, too, no matter how much money they have.

According to the latest available figures from the Bureau of Labor Statistics, the Consumer Price Index for all items excluding food and energy rose 3.2% for the 12 months ending December 2024.The CPI for all items rose 2.9% over this period.

Clients’ opinions on how well a U.S. president is managing the economy often depend on their cost of living, their income, and their wealth growth. They also consider local, state and federal tax policies when forming opinions on the effectiveness of elected leaders. What matters to them most is how much they have left to buy what they need and invest for the future.

And that’s the issue that advisors need to help clients understand: How much do they have to earn pre-tax to have sufficient after-tax income to fund a rising cost-of-living, set aside funds for liquidity purposes, and make longer-term investments to build a future nest egg?  It’s also important for your clients to understand compounding of interest and yields on investments as they relate to the compounding of inflation rates year-after-year.

Consider the Numbers

Let’s look at inflation under the Biden administration. According to the Bureau of Labor Statistics, the all-item CPI rose 7% in 2021 (Biden’s first year in office), followed by 6.5% in 2022, 3.4% in 2023, and 2.9% in 2024. Yes, the Biden administration could crow that the annual inflation rate declined as his term progressed, getting closer to the Federal Reserve Bank’s target of 2% annual inflation. But now for illustrative purposes, let’s plug some figures into the USinflationcalculator.com.

Suppose a basket of consumer goods cost $100 at the end of Donald Trump’s first term in 2020. Based on this calculator (note that statisticians come up with slightly different rates of inflation), our $100 basket of goods now cost $120.66. That’s almost 21% more at the end of Biden’s term. This overall price hike is a result of the “compounding effect” of inflation triggered from a spurt in federal spending.

The “compounding effect of inflation” erodes household or personal buying power. Increased prices in a given year become the basis or starting point for further price increases in subsequent years. This leads to a progressively larger impact on purchasing power over time, even if the rate of inflation remains constant or declines. Essentially, inflation builds upon itself, causing greater overall price increases than what the yearly inflation rate percentage suggests.

The Economic Reality

President Trump may be able to slow the annual rate of inflation, but it is not likely to go to zero unless we have a depression. The last true depression in the United States ended in 1941. We do not hope for another depression, but any future economic slowdown could cause a stock market slump. In that case we might see the reverse of a “wealth effect” — a behavioral economic theory that posits that people spend more as the value of their assets rise.

The idea behind the reverse wealth effect is that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value, especially during times of rising stock prices. They “feel richer” — even if their income and living costs are basically the same as before. However, a market slump could cause shoppers to pull back. Even now, shoppers are being more selective and we may see more price cuts or periodic sales that may ease the rate of inflation overall.

Professor Milton Friedman of the Chicago School of Economics famously said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” We know that during the Biden administration the government spent a great deal, including sending checks directly to citizens during Covid, which flooded the country with money in the face of supply chain shortages. This resulted in an inflationary surge.

During Donald Trump’s first term, inflation (measured by CPI) remained low in 2017 (2.1%), 2018 (2.4%), 2019, (1.8%) and 2020 (1.2%). The Donald’s inflationary experience “trumped” Biden’s, but inflation as a fact of life still looms large in our forward-looking planning for clients. Current concerns over a tariff and trade war, and the potential for increased pricing pressures on certain market sectors, also warrant consideration in planning assumptions.

As clients face the inevitable continued increases in their cost of living, our goal should be to help them grow their earning power each year prior to retirement, save prudently and utilize financial-planning strategies that increase after-tax growth of their nest eggs. This after-tax growth needs to occur at a rate that exceeds annual inflation rates and the ongoing compounding of inflationary price increases in living costs.

The Tax Piece

While helping clients build a nest egg, advisors typically want to see clients have a “safe money reserve” of some dimension before they consider introducing clients to more volatile investments. Money market funds are typically considered “safe money” vehicles. But according to the FDIC, the average national yield in January was 0.64% for money market accounts and 0.41% for savings accounts — virtually nothing. The highest rate paid by several banks for a 5-year CD was 4.75%, as noted by The Wall Street Journal in late January as part of the paper’s Credit Markets data report.

On February 12, 2025, with rates and yields dropping, the best rate on a 5-year CD was 4.30% and the Bankrate.com average on a 5-year CD was 2.86%. Advisors can help clients in their quest for rewarding safe money yields.

Let’s assume that “safe funds” for short- to near-term use are not in tax-deferred retirement accounts. But after taxes, how much earnings are left on a $100,000 CD or money market fund?

For some answers, I recently looked at 2022 data, the latest available, from the National Priorities Project, a nonprofit, nonpartisan federal budget research organization. That year, the average federal income tax rate was 14.5%; for the top 1% of taxpayers, the rate was 23.1%. Advisors can factor in rates for single versus married taxpayers, head of household, along with state and local income taxes based on current IRS and state tax regulations. Or an advisor could take a copy of a client’s previous year tax return and compare gross income to taxes paid to calculate an average percentage tax rate.

Let’s say our example $100,000 CD, using the 4.75% rate available in January, earned $4,750 pre-tax. Using the average federal income tax rate of 14.5%, the account holder loses $689 to federal taxes. In Georgia where I live, the account holder losses an additional 5.49%, or $261, to state taxes. Net earnings on this CD totaled $3,800 after federal and state income taxes. Higher bracket taxpayers would have less to roll over to grow on a compound basis.

Also, note that we used a yield higher (4.75%) than what most bank pay, especially the well-known behemoths. Advisors need to think about the tax implications of ordinary income tax rates versus long-term capital gains, as well as tax rates applicable to retirement plan growth and distributions, and so on. Tax planning counts!

Diversification Remains Important

While rates on guaranteed CDs and bank savings accounts have been dropping, the stock market has turned in strong performance, boosting the risk-reward ratios on U.S. and non-U.S. stocks. The S&P 500 rose by more than 23% in 2024, setting a series of record highs. Performance in the “capitalization weighted” S&P 500 was boosted by investor demand for the Magnificent Seven “superstar stocks”: Amazon, Apple, Microsoft, Alphabet (Google’s parent), Tesla, Nvidia and Meta Platforms. These “hot performers” also helped to push up the Nasdaq Composite Index of 2500 stocks by 29%. The old standby, the Dow Jones Industrial Average of 30 stocks, rose 13%.

But the money to fuel the rise of the Mag 7 had to come from somewhere, and it pulled money from other stocks and market sectors — which is what Geremy van Arkel, CFA, director of strategies for Frontier Asset Management in Atlanta, had warned. Meanwhile, sky high valuations are often warning signals for potential underperformance going forward. Diversification still counts, notes van Arkel. To manage volatility and risk, long-term investors need diversified portfolios that include large cap growth, large cap value, small- to mid-cap stocks, international stocks, etc.

To beat inflation over time, “ownership beats loanership.” Clients need to own assets that are likely to grow in value over time. Yes, interest from CDs and other cash accounts are part of a secure retirement portfolio, but price-to-earnings calculations and dividends paid by growing firms are critical to give retirees the ability to sleep soundly at night and choices when they wake up in the morning. Even more important, clients need the financial ability to handle the health challenges that accompany the rigors of aging.

So be candid with clients about the likelihood that higher prices are here to stay and that they need to proactively address this in their financial planning while also considering their tax implications and future spending needs.

Lewis J. Walker, CFP®, graduated with the third class from the College of Financial Planning in 1975. He served for many years on the board of the Institute of Certified Financial Planners (ICFP), and serving as national president and chairman. The ICFP was a forerunner of the Financial Planning Association (FPA). Honored by the FPA as a pioneer in the profession of financial planning, Lewis was a recipient of the P. Kemp Fain, Jr., Award in 2011. Now retired from active practice, Lewis continues to serve as vice chairman of the board of Atlanta-based SFA Holdings, Inc., parent company of The Strategic Financial Alliance (SFA) and SFA Partners, organizations which provide a myriad of support services to independent financial advisors.