Magic of Compounding

Magic of Compounding

$100,000 invested for 30 years grows to:

@ 5% @ 10% @ 15% @ 20%
$432,194 $1,744,940 $6,621,177 $23,737,631

 

Consider this: (the purpose of this example is to illustrate the effect of taxes, not investment returns)

Imagine that you buy a $1 investment that doubles in price every year. (Wouldn’t that be nice? This example is, however, exaggerated to illustrate a point). If you sell the investment at the end of the first year, you would have a net gain of $.66 (assuming a 34% tax bracket). In the second year, you reinvest $1.66 and it doubles in value by year-end. If the investment continues to double each year, and you continue to sell, pay the tax, and reinvest the proceeds, at the end of twenty years you would have a net gain of $25,200 after paying taxes of $13,000.

If, on the other hand, you purchased a $1 investment that doubled each year and was not sold until the end of twenty years, you would have a net gain $692,000 after paying taxes of approximately $365,000!

FV = PV (1+r)n

Understanding the Compound Interest Formula, also known as the Future Value Formula, is essential in creating wealth. ‘FV’ represents your future nest egg, or the focus of your financial goals. ‘PV’, the present value of the money you have invested today. ‘r’ is the after tax rate of return per year on your investments, and ‘n’ is the time period, or years, over which your money is compounding.

If your goal is to maximize your nest egg (FV), you need to make sure that the other components of the formula are maximized. This means -

1. investing the largest amount possible (PV)

2. maximizing the after-tax rate of return (‘r’)

3. investing for the longest period of time (‘n’)

As you can see, minimizing taxation is a critical component. You may achieve a respectable before-tax rate of return, but if it isn’t tax efficient the after-tax rate of return will be reduced by the tax paid. Tax efficiency is more readily accomplished with a buy and hold approach than with a trading philosophy, which can trigger capital gains, and thus taxation.