Compounding Can Cause Some Serious Financial Pain

29
Jun

Compounding Can Cause Some Serious Financial Pain

It’s often stated as part of conventional wisdom that you should let your money compound over long periods of time to create tremendous wealth. There are clear advantages to earning compound interest in certain circumstances.

For instance, you may have heard that a penny that doubles each day for thirty days results in over $10 million dollars. This mathmathical truth demonstrates two key points related to compounding:
The biggest gains occur at the end. In the penny example, 75% of the value comes in the last two days. This goes to show how important it is get the compound curve moving as early as possible.
Eliminating the disruptions or losses to the compound interest curve can massively improve your resultsHowever, the way most are taught to take advantage of compounding has many disadvantages and are stealing your wealth.
However, compounding can also work against you. The most devasting use of compounding is in taxable accounts (e.g. mutual funds, money market) or tax-deferred accounts (e.g 401k, IRAs).

For taxable accounts, the typical advice is to reinvest dividends and interest into the account to further the growth of the investment. Imagine you have an account with $10,000 that earns 6% per year. The $600 earned at a tax rate of 30% would result in a $180 tax bill. That doesn’t seem like much but if you were to continue this path, the tax bill would be over five times ($975 tax bill) the original amount in year 30. The cumulative total of the taxes paid over the 30 years would be $14,230.

To make matters worse, the taxes paid would be coming from another account. This creates an additional opportunity cost since you could not invest the dollars used to pay the taxes each year. In total, the taxes and lost opportunity costs would total $31,015 on an account that rose to $57,435. That’s a substantial cost to generate the gain.

For tax-deferred accounts such as an IRA, you may be thinking that you won’t be paying taxes during the compounding and could be in a lower tax bracket in retirement when making withdrawals. The truth is you’ll pay a larger amount of taxes when you defer them as the taxes are also compounding in the account. This is building up a big IOU to the IRS, and there is no guarantee the tax rates will be lower later in life. Who do you think controls the tax rates?

So what to do?

Compounding your money can help you grow your wealth as long as you consider strategies to reduce or minimize the wealth eroding factors such as taxes and lost opportunity costs. One example would be to divert any dividends or interest you recieve in a given year to another account that is tax-advantaged to flatten the tax you pay. Doing so will not only avoid building a tax liability, but will also significantly minimize the future opportunity costs.

Leveraging alternative strategies to have your money compounding safely, free from loss or taxes, and is liquid for other uses can help you reach your maximium financial potential.
Are you ready to explore strategies to reap the true benefits of compounding interest?