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The Power of Tax Deferred Compounding
Delaying, or deferring, when you pay income tax on the earnings of an investment has always provided a means to “earn interest on your interest.” The coming reduction in income tax rates can make this concept even more powerful.
Ways to Defer Income Taxes
The simplest ways to take advantage of tax deferral are with qualified retirement plans (such as a 401(k) plan or with an IRA. For purposes of discussing tax deferral, let’s ignore the potential additional benefits of any tax deduction you may get for contributions. Other ways to defer taxes include annuity contracts and even with stock investments.
How Tax Deferral Works
IRA contributions are the simplest to demonstrate. Let’s compare the difference between making $3000 annual contributions to an IRA with saving the same amounts in a taxable savings account. We will assume that both accounts earn 6% annually. For the savings account, the values are after taxes of 30% in year 2, 29% in year 3 and 28% thereafter.
Year |
Total Contributions |
IRA Value |
Savings Account Value |
|
1 |
$3,000 |
$3,000 |
$3,000 |
|
2 |
$6,000 |
$6,180 |
$6,126 |
|
3 |
$9,000 |
$9,551 |
$9,387 |
|
4 |
$12,000 |
$13,124 |
$12,792 |
|
5 |
$15,000 |
$16,911 |
$16,345 |
|
6 |
$18,000 |
$20,926 |
$20,051 |
|
7 |
$21,000 |
$25,182 |
$23,917 |
|
8 |
$24,000 |
$29,692 |
$27,951 |
|
9 |
$27,000 |
$34,474 |
$32,158 |
|
10 |
$30,000 |
$39,542 |
$36,547 |
|
15 |
$45,000 |
$69,828 |
$61,507 |
|
20 |
$60,000 |
$110,357 |
$92,344 |
|
30 |
$90,000 |
$237,175 |
$177,514 |
|
Taxes Due |
|
- $41,209 |
|
|
Net After Tax |
|
$195,966 |
$177,514 |
This chart reflects the income tax rates to be in effect as a result of the 2001 Tax Law. If we had just used a 30% tax rate for the entire chart, the funds available in the IRA would have been $193,022 and in the savings account the balance would have been $173,988. You should also know that the higher the earnings rate, the more tax deferral works to your benefit.
Why Tax Deferral Works
Continuing to earn returns on funds that would have otherwise been paid in taxes enables your funds to grow faster and to accumulate to a greater amount. The current income tax environment of coming lower marginal rates makes this strategy more powerful than ever.
For more information on this and other tax strategies, be sure to talk with CU Tax Professionals, Inc by calling 800.637.0852 x510.
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