This month 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 principal, interest on the interest and interest on the taxes you that would have paid if you were in an investment that was taxed annually.
Let me give you two examples:
1) Over 500 years ago, Christopher Columbus landed in America with two dollars. That was a lot of money in 1492. 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 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 principal. Meanwhile, 9 percent of $800,000 provides $72,000 per year with $800,000 left in principal. The two incomes would be fully taxable.
Tax deferral would have doubled your client’s retirement income with no additional risk.
Next month: the greatest financial miracle of them all.