What is the miracle of COMPOUND interest?

Financial planning is often built upon certain assumptions and built around principles believed to be true.

One of the most talked about principles in financial planning is the compounding of interest that is earned on financial products and often it is a principle that is being seen as one of the most important ways to build wealth.

In order for money to double there is a rule called “rule of 72” and that rule says that if you divide the interest rate into 72 you will see how many years it will take for the original number to become twice as large.

For example, if a number earned an annual compounding rate of 6% it would take 12 years for the number to double (72 divided by 6 equals 12).  This rule has often been used to develop financial projections and develop financial plans and the math around it works and is fairly easy. Consider an individual with $100,000 saved up in their bank account and they are expecting a 6% rate of return on that money every year. With just those assumptions we can predict that the money will grow to $200,000 in 12 years (72 divided by 6 equals 12). So that is all great and the match work but the question is whether it is accurate and a good way to predict when dealing with financial planning.

compound-interest

 

Money is not math

The main issue is that math is always consistent and there are no outside forces impacting how the numbers turn out. When dealing with money there are a host of outside economic factors that play a vital role in how money grows. Those factors include inflation, taxes, lost opportunity cost, penalties, and fees.

It is probable that the collective effect of these outside economic forces can slow down the expected profits resulting from compounding. It is therefore critical that these factors be considered when deciding how compounding should be utilized and in what scenarios it works and does not work well.

Let’s take a look at the effect of taxes

When factoring in taxes everything changes and in both taxable and tax deferred accounts the approach of compounding interest will also generate and lead to a compounding income tax.

When looking at taxable accounts, the interest when credited each year allows the account balance to grow. This is also the areas where taxes impact because as the annual interest increases, the annual income tax that has to be paid on the account increases as well.

If we assume that a taxable account is growing at a compounded rate of 6%, then at the same time the annual income tax charge is compounding at the same 6% rate.

When looking at tax deferred accounts such as a 401(k), 403(b) or an IRA the identical compounding tax is at work again. In a tax deferred account is different though and instead of the increased taxes having to be paid out of pocket the deferred accounts accumulate an embedded tax that is not payable until distributions form the account are made.

Whichever account we look at the taxes play a vital role and they take away a lot of the miraculous compounding growth.

Written By CreativeNurse Team

2016-25526  Exp. 10/17

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