My first reaction to the question of compound interest vs capital gains was “Who says I have to choose?” With the stock market slumping, there are plenty of blue chip stocks with dividend yields of 5% or more available from your friendly neighborhood broker. The dividend can help stabilize your returns and income, while owning the stock keeps you in the hunt for capital appreciation as well.
Dealing strictly from a “one or the other” standpoint, I would still chose capital gains (stocks) over compound interest (CD’s/money market/T-bills). There are several reasons for this. First is the tax advantages of capital gains compared to interest income. When you earn interest on a CD, that interest is taxed as regular income at your income tax rate whether you take the interest or leave it in the CD! By comparison, if a stock you own appreciates in value, you don’t pay taxes until you sell the stock. If you do sell after owning the stock for at least a year, you are taxed at the lower capital gains rate on your profit.
For example, if you are in the 25% tax bracket and make 5% on a $10,000 CD, your $500 of interest is taxed at the 25% rate, leaving you with $375. If, on the other hand you made 5% on $10,000 of stock and sold after a year, you would be taxed at the 15% long term capital gains rate and have $425 left after taxes. This alone is reason enough to chose capital gains over interest income, all else being equal.
Of course, in real life all else is rarely equal. The choice is usually between a lower guaranteed return from a bank CD and the possibility of a higher return by investing in stocks. For many retirees, the “safety” of the CD is very appealing and they put most or all of their money into such investments. However, there are more types of risk than simply risking loss of your capital in the stock market. Inflation, interest rate uncertainty, and increasing medical expenses are all risks that need to be taken into account, in addition to the tax differences I mentioned earlier.
On the 5% CD I used in the above example, the real return was only 3.75% after taxes. Inflation has historically been between 3 and 4%, making your real return essentially zero. That is assuming a 5% return, which in this falling rate environment is harder and harder to find. I work in a bank and see many retirees who rely on interest for income. In the last three months, rates have fallen .5-1% on most CD’s, effectively giving these people a 10-20% pay cut and often requiring them to dip into their principle to maintain their standard of living. Combine this with frequently rising medical costs and it adds up to a difficult financial situation to be in on a fixed income.
By keeping a portion of your retirement savings in a conservative portfolio of quality, dividend paying stocks you can reduce the risk of inflation and falling interest rates eating up your savings. While it is true that there is volatility in the stock market that can be avoided with CD’s, the long term growth potential is too important to ignore even in retirement. A person retiring at age 65 has at least a decent chance of living to 80 or beyond. That is a planning horizon of at least 15 years, and over such time frames stocks outperform any other investment class. Long term planning doesn’t end at retirement, it just enters a new phase. The growth potential of stocks has its place in the retirement phase too. This capital growth is vital to ensure that your savings will last as long as you do!