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How to Figure Out the Net Yield on a CD (after Taxes and Inflation)

How to Figure Out the Net Yield on a CD (after Taxes and Inflation)

With investing, it’s always important to get an apples for apples comparison so that everything is on a levelized playing field. Most of the time we look at interest rates and yield before taxes are taken out of them. If you open up a newspaper and see an advertised CD rate at 2.00% this is a before tax rate. While everyone’s taxes are different from each other, for the most part you’re going to pay ordinary income on that 2.00%.

We’ll just say for easy math you are in the 25% tax bracket. To find out how much interest you keep, use this equation:

CD interest rate x (1-your tax rate)

So, with the numbers above it would be:

2.00% x (1-25%) = 1.50%

The 1.50% is what actually ends up “in your pocket” after you pay Uncle Sam (we’ll ignore state taxes for these examples). For extra credit, it’s a good idea to factor in inflation. Money should not be ultimately thought of as a number, this is currency not money in the truest sense of the word. Money is best thought of in terms of purchasing power. Here’s a better equation to figure out whether or not you’ve increased your purchasing power; we’ll assume inflation is 3.00%:

[CD interest rate x (1-your tax rate)] – inflation rate

So, with the numbers above it would be:

[2.00% x (1-25%) = 1.50%] – 3.00% = -1.50%

This is the rate at which the investor’s purchasing power is weakening; or to state it another way, their money is losing its ability to purchase goods at a rate of -1.5% each year. To illustrate how important it is to factor in inflation, many people remember when you could walk into a bank and get a 10% CD. Let’s look back at the “glory year” in CD investing and pull out the real numbers. In that year, you could get CD rates at high as 14% and inflation was 13.5%. Taxes were higher before Reagan took office, but we’ll ignore that for consistency sake. So here’s our equation:

[14.00% x (1-25%) = 10.50%] – 13.50% = -3.00%

So, even in those days people were still losing purchasing power. You can run these numbers over the past 30 years and it’s amazing to find that historically speaking CDs on average give you a net return (after taxes and inflation) of somewhere in between -3.00% and 3.00%. At times it’s briefly gone out of this range, but a 1.00% net return is about average. Right now, the national average for a one year CD is 0.63%. In 2011, inflation was at 2.96%. Here’s the math of it:

[0.63% x (1-25%) =0.47%] – 2.96% = -2.49%

Even in these times of extremely low interest rates, the result is right within our net historical return range. Keep in mind, often the number (or currency) is only a number if you don’t factor it the current and projecting purchasing power of that number. It’s all about that number’s ability to purchase goods; in which case before you lock in a yield you have to subtract out inflation to see if your money is getting more powerful it its ability to purchase goods or not.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. CD rates are FDIC Insured and offer a fixed rate of return if held to maturity.

 

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