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Tax-Free Compounding Interest

Tax deferral is a powerful tool because it allows for tax-free compounding interest. In other words, tax deferral allows you to put more money to work. This is why many financially savvy people choose to maximize their yearly contributions to tax deferral tools like IRAs. In this post we will provide a high-level explanation of compound interest and tax-free compounding.

I. Compound Interest.

Simple interest is when interest is only tied to the original principal. Compound interest is when the principal gets interest, and then the next interest payment is calculated on the principal plus that first interest payment, and then the third interest payment includes the principal and the first two interest payments, and so on. 

Simple interest vs compound interest example: If I put $1,000 in a savings account that gives me 10% simple interest a year (“Account A”), the value of my account would increase by $100 each year. I would have $1,100 after one year, $1,200 after two years, $1,300 after three years, etc. On the other hand, if I put $1,000 in a savings account that gave me 10% compounding interest a year (“Account B”), I would make $100 in interest the first year, and that $100 would also earn interest in the second year, and the interest on that $100 would earn interest in the third year, and so on. So I would have $1,100 after one year, $1,210 after two years, $1,331 after three years, etc. After 20 years, the $1,000 that I put in Account A will be worth $3,000, and the $1,000 that I put in Account B will be worth $6,727.50.

II. Tax-Free Compounding

When dealing with the “magic” of compounding interest, small differences in initial principal become magnified over time. In fact, this is one of the clearest real-life examples of the idiom “it takes money to make money”. While it seems obvious that you would rather have $100,000 in the market working for you than $75,000, most people don’t appreciate how large of a difference that will lead to over time. Here are some illustrative examples:

Example 1, Susan Without Tax Deferral:  Susan sells her business and has a $10,000,000 gain. Susan plans to invest the gain in the market for 20 years and get an 8% rate of return. Susan pays 30% tax on her $10,000,000 gain and invests the remaining $7,000,000 in the market. With a compounding 8% return, in 20 years Susan’s $7,000,000 investment will increase to approximately $32,600,000. When Susan wants to access those gains she will have to pay 30% on the new $25,600,000 as well. So, without tax deferral, Susan is left with a total of $24,920,000.

Example 2, Susan With Tax Deferral: Susan sells her business and has a $10,000,000 gain. Susan plans to invest the gain in the market for 20 years and get an 8% rate of return. Susan is able to defer taxes on her gain and invests the entire $10,000,000 in the market. With a compounding 8% return, in 20 years Susan’s $10,000,000 investment will increase to about $46,600,000. Susan pays 30% in taxes on the entire $46,600,000 and is left with $32,620,000. In other words, tax deferral provided Susan with an additional $7,700,000 in wealth creation!

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