How inflation affects your savings
Inflation is the general rise in prices. If your money does not grow at the same pace, it buys a little less each year, even though your balance has not changed. It never shows up on a statement, which makes it easy to underestimate.
What idle money loses
Here is what $10,000 earning nothing could buy, in today’s dollars:
| Annual inflation | After 10 years | After 20 years | After 30 years |
|---|---|---|---|
| 2% | $8,203 | $6,730 | $5,521 |
| 3% | $7,441 | $5,537 | $4,120 |
| 5% | $6,139 | $3,769 | $2,314 |
The gap between 2% and 3% looks small, but after 30 years it is worth $1,400 in buying power. Inflation works just like compound interest, only against you.
Try other numbers in the inflation calculator.
Nominal vs. real return
Your nominal return is what you see on your statement. Your real return is what remains after inflation, and it tells you whether you can actually buy more than before.
Real return = (1 + nominal) ÷ (1 + inflation) − 1
Simply subtracting the two gets you close, but the formula is more accurate. With 3% inflation:
| Nominal return | Real return | What it means |
|---|---|---|
| 0% | −2.91% | You lose buying power |
| 2% | −0.97% | Your balance rises, but buys less |
| 4% | 0.97% | You get slightly ahead |
| 7% | 3.88% | You get clearly ahead |
The second row is the most misleading. Your balance goes up and the statement looks good, but at the end of the year you can buy less than before.
There is one more step. Your return is often taxed, and tax applies to the nominal gain, with no adjustment for inflation. So your after-tax real return is lower than this table shows.
Why your inflation may differ
The official US measure is the Consumer Price Index from the Bureau of Labor Statistics. It tracks a typical basket of goods and services, but nobody buys exactly that basket:
- If you rent, housing costs may hit you much harder than someone with a fixed-rate mortgage.
- If you have a long commute, gas prices matter more.
- If you are older, you may spend more on health care.
This also matters for your paycheck. If your salary rises 10% during a period when prices rise 12%, your buying power has fallen, even though you are earning more.
What to do about it
Do not take more risk with short-term money. Your emergency fund and anything you will spend soon will lose a bit of value, and that is a fair price for having it available. Investing it to avoid inflation could force you to sell at the worst time.
Earn something on your cash. If you hold more than you need in a checking account, a high-yield savings account or CD can reduce the damage without market risk.
Adjust long-term goals. Something that costs $10,000 today would cost about $18,061 in 20 years if prices rise 3% a year. Set a goal without adjusting for that, and you will fall short. The savings goal calculator can help you set your contribution.
Judge investments in real terms. Compare the annualized return to inflation over the same period. An investment returning 11% a year during 3% inflation had a real return of 7.77%.
Consider inflation-protected options. US Treasury Inflation-Protected Securities (TIPS) and I bonds are designed to adjust with inflation. Read how they work before buying: their rules and tax treatment differ from those of ordinary savings products.
Rethink fixed-rate debt. A fixed-rate loan becomes easier to carry if your income rises with inflation. That is no reason to borrow, but it is worth considering when you decide between paying off debt and investing.
Which inflation rate to plan with
Nobody knows what inflation will be in 20 years. The Federal Reserve targets 2% over the longer run, which is a reasonable starting point. Rerun your numbers at 3%, and ideally 4%, to see what happens if prices rise faster than expected.
If your plan only works in the optimistic case, it is not as solid as it looks. It is better to find out now, with years left to adjust, than to discover it at the end.