Options Can Help Conquer the Double Threat of Inflation and Taxes.

How much net return do you need to break even? It might be much higher than you think. The double effect of inflation and taxes can destroy a modestly-yielding portfolio, and this is where options can be valuable. A program including covered calls, for example, can at times accomplish double-digit returns and as long as underlying securities are chosen wisely, the downside risk is no greater than just owning shares.

Here is how to figure out your breakeven requirement: Divide the rate of inflation by your net after-tax income (100 minus your effective tax rate). For example if you think inflation is 2% and your effective tax rate — the rate you pay on any additional income this year — is 40%, your breakeven is 3.33% ((2% / 100 – 40) = 3.33%

Is your effective tax rate really as high as 40%? It might be even higher. For example, if your federal tax rate is 33% and your state tax rate is another 9%, your combined is 42%. So on every dollar you earn that goes into taxable income, you owe federal and state income taxes of 42 cents.

Below is a chart summarizing the breakeven rate for various levels of inflation (across the top between 1% and 5% and for each tax rate between 14% and 52%). For example, at 3% inflation and effective tax rate of 52%, you need to earn 6.3% net on your portfolio just to beat inflation and taxes.

Breakeven rate

tax rate  1% 2% 3% 4% 5%

14% 1.2% 2.3% 3.5% 4.7% 5.8%   

16 1.2 2.4 3.6 4.8 6.0      

18 1.2 2.4 3.7 4.9 6.1      

20 1.3 2.5 3.8 5.0 6.3      

22 1.3 2.6 3.8 5.1 6.4      

24 1.3% 2.6% 3.9% 5.3% 6.6%   

26 1.4 2.7 4.1 5.4 6.8      

28 1.4 2.8 4.2 5.6 6.9      

30 1.4 2.9 4.3 5.7 7.1      

32 1.5 2.9 4.4 5.9 7.4      

34 1.5% 3.0% 4.5% 6.1% 7.6%   

36 1.6 3.1 4.7 6.3 7.8      

38 1.6 3.2 4.8 6.5 8.1      

40 1.7 3.3 5.0 6.7 8.3      

42 1.7 3.4 5.2 6.9 8.6      

44 1.7% 3.6% 5.4% 7.1% 8.9%                           

46 1.8 3.7 5.6 7.4 9.3

48 1.9 3.8 5.8 7.7 9.6

50 2.0 4.0 6.0 8.0 10.0

52 2.1 4.2 6.3 8.3 10.4

Michael C. Thomsett

www.MichaelThomsett.com www.ThomsettPublishing.com