Determining an appropriate inflation rate to use for retirement planning purposes is important. Inflation reduces your purchasing power; for example, it makes $100,000 today worth significantly less than the same amount in 20 years. The actual worth depends on the inflation rate. Using the consumer price index, $100,000 in 1980 would have the same buying power as $282,492 in 2013.
Consumer Price Index
Most United States government entities use the consumer price index. The CPI is calculated and published by the Bureau of Labor Statistics. The CPI compiles data on prices that urban consumers pay for a grouping of goods and services. According to the Tax Foundation, average annual inflation rates in the U.S. between 1984, when the IRS began indexing to inflation, and 2010 ranged from 0.19 percent to 5.28 percent.
Average Inflation Rates
Many financial institution websites use an average of 3 percent when discussing retirement planning. This is because the rate of inflation since 1926 has roughly averaged 3 percent. However, the inflation rate has been as high as 14.4 percent in 1947 and as low as -9.9 percent, which is actually classified as deflation, in 1932. More recently, according to the US Inflation Calculator, which uses CPI data, inflation averaged 2.5 percent for the 20-year period between 1993 -2012.
The Internal Revenue Service typically releases its inflation rate-adjusted numbers in January for that calendar year's taxes, for taxes that you will file the following year. The inflation rate the IRS uses affects the maximum allowable contributions to IRAs and 401(k)s. It also affects the salary range and cut-off for deductible traditional IRA contributions and the amount allotted for personal exemptions and standard deductions. In its calculations, the IRS compares a base average to an average CPI-based monthly value from the preceding 12 months.
Inflation Rate Predictions
It is impossible to predict inflation rates. Although the past is not a predictor of the future when it comes to investing and inflation, analysis of the past does provide information about trends. Look at trends and averages to help you determine the best inflation rate, conservative or aggressive, to use for your planning. The 1970s was a period of high inflation, where inflation averaged 7.08 percent for the decade. The next highest was the 1940s with a 5.63 percent average. However, most decades experienced lower inflation. The most recent deflationary year was 2009.
Your belief about inflation rates and the amount you can save annually both impact how much risk you may need to take with your retirement investment portfolio. The number of years until retirement and your expected lifestyle in retirement also affects your risk level. Conservative, low-risk products including bonds and certificates of deposits all offer a fixed interest or return and therefore, are the investment products adversely impacted the most by inflation. Conversely, growth stocks, exchange-traded funds and mutual funds are the least tied to inflation.
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