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The Magic of Compounding, and the Tyranny of Taxes


Today I want to talk about something that is often ignored, yet has a very large impact on the net performance of our trading and investing: Taxes. To illustrate the importance, I often like to point out both the power of compounding and the impact of taxes with a simple example.  

If you could double a dollar every year, for 20 years, how much do you think it would be worth? Before glancing down, I'd really encourage you to take a guess first...So for example, I'm saying:

 

$1

End of year 1. $2

End of year 2. $4

End of year 3. $8

 

And so on, for a total of 20 years...Now go ahead and stop, without cheating, and make your guess. Doing this with people for more than a decade now, I get answers that have a wide range, but are consistently below the actual result. And usually not even close. So here we go:

 

  $1
1 $2
2 $4
3 $8
4 $16
5 $32
6 $64
7 $128
8 $256
9 $512
10 $1,024
11 $2,048
12 $4,096
13 $8,192
14 $16,384
15 $32,768
16 $65,536
17 $131,072
18 $262,144
19 $524,288
20 $1,048,576

 

Is your mind blown? Don't feel bad if you guessed something that wasn't even in the thousands...there is a reason why Einstein referred to compound interest as the 8th wonder of the world! Now, obviously there isn't an investment that can sustain this kind of performance, it's just an example to drive a point, but even a $100/month investment at 12% annualized return can turn into more than $1,000,000 over 40 years. That means it's very realistic for a 25 year old entering the work force to retire as a millionaire at age 65, regardless of salary, based on historical stock market trend line performance. Time is our greatest asset. And taxes are our greatest liability...so let's keep this example moving along with that in mind.

 

If the example above were held in a tax free vehicle, such as a Roth IRA/401(k), Health Savings Account, or in certain situations a properly designed low fee cash value life insurance policy, the $1 million could potentially be yours to keep, income tax free. If the $1 million was protected by a tax-deferred vehicle such as a Traditional IRA/401(k) or a low fee variable annuity, the earnings could be tax deferred until withdrawn. This is also true to a large degree with certain tax managed equity mutual funds and ETF's that are able to avoid capital gain distributions.

 

But what if this example was exposed to income tax on the earnings every year at the current top Federal rate of 37%? Like before, guess what the ending value would be...So to be clear...

 

$1

End of year 1: $2 minus income tax (37% of $1 = $0.37)...$1.63

End of year 2: $1.63 * 2 = $3.26 minus income tax (37% of $1.63 = $0.6031)...$2.66

And so on, again for a total of 20 years...Make your guess now on the ending value.

 

  $1.00
1 $1.63
2 $2.66
3 $4.33
4 $7.06
5 $11.51
6 $18.76
7 $30.57
8 $49.83
9 $81.22
10 $132.40
11 $215.81
12 $351.76
13 $573.38
14 $934.60
15 $1,523.40
16 $2,483.14
17 $4,047.52
18 $6,597.46
19 $10,753.86
20 $17,528.80

 

Is your mind blown again? The bad news is that we can't really control what the financial markets do, but the good news is that we have a reasonable degree of control over protecting our investments from income taxes. It just requires we pay attention to the vehicles we put our money into, and the type of trades and strategies we execute in taxable accounts. Many traders and investors ignore the impact of taxes when considering a product or strategy, but it's simply unwise to do so if you're in a high tax bracket. It's not how much you make, but how much you keep, net of all fees and taxes.

That's especially true if you're also in a state with a high state income tax rate, such as CA or NY. Tax efficient vehicles, and tax efficient investment products and strategies are available to everyone today. As a CFP® professional, I can help my clients build long term financial plans and investment portfolios that align with both their unique willingness and need to take risk, as well as their unique tax situation. 

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.

Edited by Jesse

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