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With inflation rising, how will your retirement savings parked in overseas investments get affected? Image Credit: Shutterstock

Dubai: Globally, prices have been rising on everything from food to housing. But what about your retirement savings parked in overseas investments? Will they be affected?

Most people understand inflation increasing the price of their groceries or decreasing the value of the currency in their wallet. In reality, inflation can also take a bite out of your investment returns over time.

To combat inflation, most countries worldwide hike interest rates, and while that leads to higher savings growth rate on your retirement funds, there is one commonly overlooked downside.

With higher interest rates, also comes higher taxes incurred on such deposits or investments. So while inflation takes a chunk out of your hard-earned savings, so can taxes. Let’s delve into both aspects.

How can inflation affect your retirement investments?

Historically, statistics show that assets with fixed, long-term cash flows tend to perform poorly when inflation is rising, since the purchasing power of those future cash flows falls over time.

Conversely, commodities like gold and assets with adjustable cash flows (e.g., property rental income) tend to perform better with rising inflation.

“Inflation can shrink your savings even if you’ve secured your funds in a savings account with an average interest rate,” explained UAE-based financial planner Andrea Barber.

“In theory, when you’re working, your earnings should keep pace with inflation. When you’re living off your savings, as in retirement, inflation diminishes your buying power. It’s important to factor inflation into your retirement savings to ensure you have enough assets to last through your retirement years.”

Isn’t putting money in fixed income investments safe when inflation or taxes rise?
Isn’t putting money in fixed income investments safe when inflation or taxes rise?
Typically, investors buy fixed income securities such as bonds because they want a stable income stream in the form of interest payments. But even though it makes logical sense, in reality, that may not be the case.

“However, since the rate of interest remains the same on most fixed income securities until maturity, the purchasing power of the interest payments declines as inflation rises. So bond prices tend to fall when inflation is increasing,” said Brody Dun, investment manager at a global asset management firm.

One explanation is that most bonds make fixed interest, or coupon payments. Rising inflation erodes the purchasing power of a bond’s future (fixed) coupon income, reducing the present value of its future fixed cash flows.

“Accelerating inflation is even more detrimental to longer-term bonds, given the cumulative impact of lower purchasing power for cash flows received far in the future,” added Dun. “Riskier high-yield bonds typically provide higher incomes, and have a larger cushion than counterparts when inflation is rising.”

Why do taxes on overseas investments go up with inflation?

Each year, most governments worldwide adjust ‘tax brackets’ (a range of incomes taxed at a given rate) for changes in the cost of living to calculate tax liability by the country’s citizens to the economy. “If an economy typically faces inflation each year, the tax brackets are adjusted upward,” Barber noted.

“When inflation rises, the nominal amount of such income rises, as does the tax owed on that income, even though the value of the income is unchanged. Thus the tax on income is higher in an economy with higher inflation than in an economy with lower inflation. In the UAE, however, no personal or investment income is taxed. This applies only if you have retirement savings overseas.”

Dun further explained that investments held for more than 24 months are considered long-term, and a ‘capital gain tax’ (tax on the profit made on the sale of an asset) is applicable, which depends on the country your investments are in.

“For investments held for less than 24 months, short-term capital gain from the sale of investments is added to the total income and taxed at per the individuals’ tax bracket (provided the investment income is taxed in the country).”

Inflation and taxes can have a significant impact on your investment portfolio over time.

What investments are affected by inflation-induced taxes?

Given that taxes apply on investments in the country you plan to retire, inflation-induced taxes can affect multiple sectors. Let’s say you buy a property which you hope to fund your retirement with.

“While homeowners are likely happy to see the value of their homes rising, they won’t be so excited when their property taxes go up at their next income tax assessment,” Dun added.

“They can also expect to face higher insurance premiums on their inflated home values. The cost of utilities is rising. Renters aren’t immune to these inflationary pressures, since landlords pass along their inflation-driven costs.”

Dun also noted that those who retire on retirement funds with little or no cost-of-living adjustments also will see a reduction in their standard of living.

Verdict: How to defend your portfolio against inflation, taxes

Inflation and taxes can have a significant impact on your investment portfolio over time. Alongside working with a financial professional, consider diversifying your portfolio to protect your investments.

Diversifying your portfolio with exposure to stocks and real assets such as commodities may help you shield your money against inflation. However, diversification and asset allocation do not protect against losses or guarantee returns.

“Inflation and higher taxes might be beyond your control, but that doesn’t mean you can’t take actions to help preserve your investments and savings from its effects,” Barber further noted.

“In times of rising inflation, it is good to check in with an advisor to ensure you have the right investment allocation to match your appetite for risk.”

To illustrate, consider a moderate 60 per cent equities and 40 per cent fixed income asset allocation. Dun explained that if you are income-focused, consider shifting a portion to dividend-paying stocks.

“In the past, stocks have been able to keep up with inflation better than bonds. Additionally, limiting exposure to tax-related losses by investing for your post-retirement future in countries with less taxes are a definite plus.”