Wealthy people are very careful to make sure their money is put to work earning more money for them, and they never keep their money in a bank account. Keeping money in a bank account feels safe, you can log in to your bank and expect to know what the amount will be. But it’s also losing your buying power.
This article is going to convince you why you should be investing instead of putting money in a bank, even a high-yield interest savings account.
For this example let’s say that you put $50,000 in a high-yield interest savings account at the beginning of 2018, and it earned an average of 2 percent interest. At the beginning of 2019 you would have an extra $1,000. However, once you factor in inflation and taxes, your money might actually be losing buying power. That interest you earned is counted as income, adding to your total income amount when you’re doing your taxes. Even if you make under $100,000 a year you still could have to pay nearly a quarter of your interest income back to the government in taxes.
To make things even worse, inflation in 2018 was 2.44 percent meaning that your $51,000 has $1,244 less in buying power at the beginning of 2019, compared to the beginning of 2018. After including your $1,000 of interest income, but deducting $1,244 in inflation and $250 of tax, your original $50,000 now only has $49,506 in buying power.
2018 was a bad year for the stock market, but with the stock market, it’s all about averages. If you had invested $50,000 in Vanguard’s Total Stock Market Index Fund at the beginning of 2018 you would have lost 5.17 percent when including dividends, for a total loss of $2,585 (it would have been a decrease of 6.94 percent without dividends) . Dividends are quarterly payments that some corporations pay as a return to their shareholders. Unlike interest from a bank account, dividends also receive special tax treatment.
However, if you look at the past three years you would have had a total return of 22.45 percent and 28.63 percent when you include dividend returns, dividends averaged almost 2.1 percent per year over the last three years. If you had invested the $50,000 at the beginning of 2016 it would have increased in value by $14,315, when you include over $3,000 in dividends. These returns are almost exactly the same as the historical average of a 7 percent yearly return from the stock market.
When adding inflation and tax, the stock market is still a much better place to keep your money than a bank account. Inflation over those three years averaged closer to 2.15 percent and tax on capital gains is far lower than tax on income, which is how interest on a bank account is taxed. The capital gains tax is 0 percent for people who earn under $40,000; 15 percent for people who earn between $40,000 and $434,000; and everyone else pays 20 percent. To qualify for capital gains tax you have to have owned the stock for at least one year before you sell it. To get the capital gains tax on dividends you have to own the stock for at least 60 days in the period before the dividend is paid out.
Here is an example, $50,000 invested in 2016 would be worth $64,315 at the beginning of 2019. However, three years of inflation will have reduced the buying power by $3,923. Now, assuming that you make less than $434,000 but more than $40,000, your tax rate will be 15 percent. This means you’ll have to pay $2,147 in taxes, but only when you cash out your investments. This is another advantage over keeping your money in a bank account because your savings will keep earning more income instead of being taxed. In total, the $50,000 you invested in 2016 would have $58,245 in buying power in 2019 after inflation and tax. For a $2,750 increase in buying power on average per year.
Keeping $50,000 in stocks compared to a high-yield savings account would have earned you an average of $3,250 more in buying power per year over the three year period of 2016 through the beginning of 2019.
Investing in the stock market is far scarier than investing in a bank account. As many of us remember, 2007 and 2008 were terrible years and people lost huge percentages of their wealth. However, it only took a few years for all of that wealth to come back and then a whole lot more. If you’re saving for anything that is more than a year or two away it is far better to invest in the stock market instead of a savings account. Don’t get spooked when the stock market goes up or down, the longer you can keep your money in the stock market, the better.
I have written several related Medium articles on taxes and investing:
- Here is an article about investing during the COVID-19 crisis.
- The most pertinent one is about whether it’s smarter to invest with an investing app like Robinhood or strictly investing in an index fund with a company like Vanguard.
- Another is called Taxes on Savings are Unfair, Here’s How to Fix it.
- Lastly, here is an important one called Did you Receive a Smaller Tax Return? Next Year Will be Worse.