Does the miracle of compounding returns affects taxes

When you went to school you most likely learned about compounding and you saw how numbers when compounded would grow larger and larger at a faster and faster pace. In the more complex world of financial planning consumers are also often being told that compounding is the most important part of a financial plan. The truth is that compounding also occurs when we are dealing with money and investment accounts but most advisors don’t paint a complete full picture of what actually happens inside and outside of the savings or investment account.
The general concept of compounding does sound very great and it does work but there are other forces that come into play when we are dealing with money that does not affect the numbers around plain math.

Let’s take a look at a very simple. If you went to the bank and you purchased a Certificate of Deposit (CD) the money inside the CD would stay inside the CD and the interest that is earned on the CD will also stay within the CD and will now also earn interest. This sounds good since the money now will grow faster as the interest and principal balance are both growing. The number that the CD grows to is what you will see on your statement and once you pull out your money it seems it was a very good investment and it seems you earned some nice interest.
So what is the problem?
The missing piece of information that most advisors leave out is that you are paying out of pocket taxes on the interest that is earned. You will actually be taxed every single year on the interest earned on the CD. That means you have to come up with money from other sources to pay the interest which demolished the real actual rate of return that you got.

Diversify the types of accounts that you have in place and minimize the accounts that are tax inefficient.

If the CD statement would show what tax would be owed at the end of the year that future tax liability would grow simultaneously with interest being earned. This is extremely important to recognize when picking and choosing where to invest your money and how to analyze rates of returns.

The whole idea around compounding interest is a good thing and it does grow your wealth over time but the true growth is also hindered by the growth of taxes that has to be paid out of pocket. In tax deferred qualified retirement accounts, the same problem exists even though it is not as obvious the taxation does not occur until distributions of the assets take place.

The solution to all this is to diversify the types of accounts that you have in place and minimize the accounts that are tax inefficient. You should have short term liquid money in some sort of savings account that is not correlated to the market and you might need to have some deferred retirement accounts but there should also be other accounts in place where taxes are not a factor or where the affect of taxes are very limited.

Written by CreativeNurse Team
2016-28983 Exp. 10/17