Today we are going to review the financial “miracle” of tax-deferred compound interest. Tax deferral provides amazing results because it employs triple compounding: It pays interest on the principle, interest on the interest and interest on the taxes you that would have paid if you were in an investment that was taxed annually.
Most people do not understand the amazing benefit of tax deferral. They think taxes should not be deferred if the rates will be higher in the future. But higher taxes actually increase the impact of tax deferral because you are receiving interest on the taxes you would have paid. This magnifies the compounding effect, which makes tax deferral even more beneficial.
Let me give you two examples:
1. More than 500 years ago, Christopher Columbus landed in America a very wealthy man. He had brought two dollars with him. That was a lot of money in 1492. Columbus was faced with a difficult decision about where to invest this money. Should he put his money in the “New World” bank or the “Old World” bank? Being an astute investor he allocated one dollar to each bank.
The dollar in the Old World bank paying 5 percent simple interest would be worth $26 today. The dollar in the New World bank paying 5 percent compound interest would be worth $39,323,260,000. What if Columbus had been taxed at a 50 percent tax rate all those years? His simple interest investment would be worth $13 today, and his compound interest investment would have fallen to a value of only $230,109. Not using tax deferral would have cost Columbus $39,323,029,891.
2. I show my prospects that a $100,000 investment at age 40 paying 9 percent and paying taxes on an accrual basis at a 33 percent rate will grow to $400,000 by age 64. If my client earns the same interest rate and defers taxes until withdrawal, that same investment will grow to $800,000. Even if tax rates increased to 50 percent and taxes were paid on the gain in a lump sum, at age 64, he would still net $450,000 after taxes. That is $50,000 better than paying taxes on an annual basis.
A good advisor would point out that 9 percent of $400,000 pays $36,000 per year in retirement income with $400,000 staying in principle. Meanwhile, 9 percent of $800,000 provides $72,000 per year with $800,000 left in principle. The two incomes of $36,000 and $72,000 would be fully taxable. Which would you rather have? Tax deferral would have doubled the retirement income of your client with no additional risk. That is a financial miracle. This concept will guarantee your success. Share it with everyone. Assume your client doesn’t know. They don’t.
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Van Mueller has spent 37 years working in the insurance business, and has held Top of the Table status with the Million Dollar Round Table for more than a decade and was also Senior Market Advisor’s 2010 Advisor of the Year. For more information, go to www.vanmueller.com.