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.