Albert Einstein (1879-1955) called it the 8th Wonder. I have often wondered if he would share the same conclusion today given that many circumstances have changed over the years. When Einstein made this statement, we did not have the complex tax structure we have today. It is my conclusion that compound interest creates another problem of compound tax.
For years we have all heard, “It’s not what you earn that counts, it’s what you keep.” This rule also applies to this mathematical phenomenon so let’s examine this a little closer. This week I will discuss a situation where one defers money and allows it to compound over a 20-year time-frame. Next time, I will discuss a different scenario.
I consult with several business owners and I often ask, “What are the factors that aided in the decision to save aggressively into their qualified retirement plans.” The reply I often hear, “To save taxes.”
A 45 year old is saving $16,500 a year in their retirement plan earning 6 percent. In 20 years, they would have an astonishing $643,380. To celebrate his retirement, he contacts the institution that has his account and request to have his balance sent to him in a lump sum. Because they have worked with this individual for 20 years, the institution knows all of the factors regarding his financial circumstances withhold the necessary taxes for federal and state taxes.
The following day he received the check in the mail and the amount was $388,923. He immediately phoned them and said there must be some mistake since his account was almost $650,000 for which the customer service representative replied, “Yes sir, however we withheld the taxes that were due.”
After he phoned the RV dealer and told them to cancel the order on his new 33-foot RV that he was going to travel the 50 states, he picked up a calculator and did some mathematical computations. *For 20 years he had saved $16,500 for a total of $330,000. His net sum of $388,923 left him a gain of $58,923. Further calculations revealed that while he thought he was earning 6 percent for his hard work and effort, his net rate of return was 1.54 percent.
Questions to consider? Did he save the taxes he thought he was saving and did he create more enjoyable, spendable wealth?
*Source MoneyTrax developed within the Spending Game Module
Steve Temple is a senior partner with Ohio Financial Center with locations in Dublin and Troy. With 22 plus years in his industry, he has written numerous columns both locally and nationally.