Compound interest — the rest of the story


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.

Last week we revealed the outcome of saving money in a tax deferred account. This week we will use an example with a traditional after-tax account. In this scenario we have a male 35 year old that is going to save for 30 years. We will use 6 percent for rate of return, 35 percent federal tax and 7 percent for state tax. He currently deposited $25,000 in this account and will let it grow for the next 30 years. This strategy follows the typical recommendations given to most consumers.

A simple computation of Time, Value Money will reveal that he will have a whopping $143,587 in his account by age 65; however, this is not totally accurate when we must consider what it cost to grow this wealth. Each year he will get a 1099 for all of his hard work and effort. By the time he is ready to access the $143,587 that he worked so hard to save by age 65, he will have paid approximately $29,000* in cumulative federal and state taxes.

The problem with this approach is that most have been taught to measure their success in watching their balance grow. Little do we know or realize is that it cost $29,000 of taxable gains which becomes a significant erosion of wealth. To make matters worse we must also consider the lost opportunity costs (LOC) on the taxes that were paid. Those dollars are no longer working for the individual to grow wealth. When adding the LOC of $35,000 with the $29,000 taxes that were paid, together these total $64,000. In this scenario it is incontestable that we have over $143,000, it simply cost $64,000 to accomplish this.

Questions to consider? Other than a ROTH account that has all sorts of limitations, are there other alternatives to have more enjoyable, spendable wealth?

*Source Money Trax developed with The Spending Game

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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.

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.

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