Inflation is the enemy when it comes to your savings because it attacks real returns, and reduces the purchasing power of your cash.
Inflation is the enemy when it comes to your savings because it attacks real returns, and reduces the purchasing power of your cash.
What is inflation?
In simple terms, inflation means the price of everyday goods and services we buy is rising. The government’s favoured measure of inflation is known as the Consumer Prices Index or CPI. The CPI is currently 3.1% which means prices are 3.1% higher now than they were a year ago.
Why does inflation matter?
When inflation is high the same amount of cash will buy less than it could the previous month or year. Hopefully, your salary will rise in line with inflation at least, so you can continue to buy just as much as you could before. People on fixed incomes are particularly vulnerable to high inflation, and it’s also bad news for savers.
Why does inflation affect my savings?
To earn a real return on your money, you’ll need a savings account with a rate high enough to beat tax and inflation. If you’re a basic rate taxpayer, you’ll lose 20% of your interest to the taxman. In other words, if your savings rate is 4% before tax, it’ll be 3.2% after tax with the 20% deduction.
From the net 3.2% rate, you’ll have to take away the rate of CPI inflation next. So, since the CPI is 3.1%, your real return in this case is actually 0.1%. Putting it another way, for a basic rate taxpayer to beat tax and inflation, they would need to earn a rate on their savings of more than 4%.
For a higher rate taxpayer to earn a real return they would need to earn a gross rate on their savings of more than 5.33% as they’ll lose 40% of their interest in tax.
Is it possible to earn rates this high?
Right now, it’s impossible to get rates good enough to beat tax and inflation on easy access savings. You may be able to by choosing a fixed rate ISA or bond, but you will need to lock your money away for four or five years.
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