Understanding (And Avoiding) the Money Illusion

Inflation plays a major role in financial planning whether you are conscious of it or not. The money illusion refers to a cognitive bias that fails to take inflation into account. In this week’s blog, we’re digging into how the money illusion can impact your long-term financial planning.

What is the Money Illusion?

According to Seeking Alpha, money illusion (or price illusion) is the tendency to think of your income in nominal values versus real terms. When you think of something in nominal terms, you fail to consider external factors such as inflation.

Of course nominal value is not the same as real value. The clearest explanation of this compares wage increases with inflation. If you get a 5% raise at work, but inflation is 7%, you are at a net loss of 2% in terms of real value. Focusing only on the nominal increase (in this case, 5%) gives the illusion that you are better off. Over the course of just one year, it’s not the end of the world, but this illusion can be damaging over the long-term.

How The Money Illusion May Impact Financial Planning

As you can see, the money illusion is a tricky cognitive bias. Over the course of your long-term financial planning, it may put you behind your goals. If you think you need $1 million to retire comfortably in today’s real terms, what does that equate to in 10, 20, or 30 years when you are actually ready to retire? You will likely need more than $1 million to retire comfortably as you race inflation. Inflation is an important consideration when you are modeling cash flows and planning for your future.

How inflation impacts taxes is another important consideration. Several parts of the current U.S. tax code include provisions that aren’t updated from year-to-year to reflect how real values are changing. Taxes related to these non-indexed or non-inflation-adjusted provisions are often referred to as “stealth taxes”. They are stealth in the sense that they fly below the radar. Many people don’t recognize that they aren’t adjusted to inflation. And in the current environment where wages, the markets, and real estate prices have seen significant recent gains, these stealth taxes are impacting more and more people.

How to Combat The Money Illusion

Without acknowledging inflation and the real buying power of your income, you may slowly fall behind on your financial goals. But, by building out a solid financial strategy and understanding the current economy, you can combat the money illusion and understand how much money you actually need to pursue your long-term goals.

One way to do this is to understand how inflation works and the current rate of inflation. This will help you understand how much you have to make to keep up your buying power.

Another way is to work with an advisor. At Heritage, we help our clients build a long-term financial plan that takes inflation expectations into account. But we also want to understand your near-term goals and intentions. Frequent meetings allow for on-going communication about near and long-term plans. Those stealth taxes we mentioned can’t be avoided. But careful year-to-year planning and good communication with your advisor can help to minimize the impact of higher taxes. And it also helps ensure that there’s no surprises when tax time rolls around.

Resources that Can Get You Started

Heritage provides a number of resources to help our clients and followers stay up-to-date on what’s happening in the markets and economy. Here’s a sample:

And if you’re wondering if stealth taxes might take a bite out of your income this year or in the next few years, join us on Thursday, February 17th at 11:30 am EST to learn about the top stealth taxes that are impacting more and more taxpayers, and how you can manage your exposure to them. If you are interested in learning more but can’t make it live, register here and we’ll be sure to send you a replay.

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