Financial Myth - The Miracle of Compounding Interest
By Jeffrey W. Kirshner, CPA*, PFS, MBA
Albert Einstein has long been quoted as saying, “Compound Interest is the Eighth Wonder of the World.” In fact, many financial planning recommendations and actual wealth building strategies rely on the compounding or reinvestment of interest earned on a financial asset in order to achieve a variety of financial objectives. The practice of “compounding” is commonplace in most financial circles and has been largely held in high esteem by both consumers and professionals alike.
With the discovery of the Exponential Curve, mathematicians were able to calculate how long it would take for a sum to double. Also known as the Rule of 72, one can simply divide an assumed interest rate into 72 to determine how many years are required for the final number to be twice as large as the original number. For example, if a number were to be compounded annually at a 6% rate, then it would take 12 years to double. If that amount were to compound annually at 8%, then it would take 9 years to double.
To put this in real numbers, consider a person who has $100,000 sitting in the bank today and expects to earn 6% in interest each year (yes, I know, this is a big assumption in today’s environment). With these assumptions, the $100,000 can be expected to grow to $200,000 in 12 years. This $200,000 would then double again over the next 12 years so that the total account is worth $400,000 after 24 years.
This sounds like a wonderful strategy, but accumulating wealth is more than just math. As I’ve said for years, “Money is not math, and math is not money.” So, how could this miracle of compounding interest not be such a miracle?
Simply put, compounding interest leads to compounding taxes. In both taxable and tax deferred accounts, the strategy of compounding interest will lead to a compounding income tax.
In taxable accounts, as interest is credited each year, the account balance will grow – which is good. However, as annual interest increases, so too will the annual income tax increase that is due on that account. The annual out-of-pocket income tax liability is compounding (or increasing) at the same 6% rate! And, if you continue to add money to the account each year, the problem is magnified.
Let’s build a brief example. Assume a person has $100,000 in a taxable account, makes deposits of $10,000 into the account at the beginning of each year, earns a conservative 5% each year and is in a 40% income tax bracket. After the first year, the account balance has grown to $115,500, which is simply the initial balance of $100,000 plus the deposit of $10,000 and 5% growth of $5500. In a taxable account, though, this growth of $5500 is taxed at 40%, so the person in this example will owe $2200 in taxes in Year 1.
If we employ this strategy over an extended period of time and maintain the same assumptions throughout, then in Year 18, the income tax owed will be $10,211, which is more than the annual deposit. In the 25th year, the tax liability would grow to nearly $16,000!
If the person in our example is so lucky as to receive 10% every year, with all of the other assumptions remaining the same, then the “crossover period,” or the year in which the tax liability exceeds the annual deposit would be in Year 7, at which time the tax liability would be $10,881. In the 25th year, the tax liability would be over $78,000.
I am no Einstein, but this does not appear to be a miracle to me. Who would do this every year?
I know what you’re thinking. If I instead put all of this money in my tax-deferred retirement plan at work, then I avoid this problem altogether. This appears to make sense on the surface, and the common financial advice is to maximize retirement plan contributions at work because you get a deduction and then the money grows tax-deferred.
Here’s the flaw with this. With tax deferred accounts, the same compounding tax is occurring. However, as opposed to increased taxes being paid out of pocket each year, deferred accounts postpone the tax until distributions are made, typically around age 65, at which time, all the withdrawals are subject to the ordinary income tax rates in effect at that time. It is entirely possible that you could defer into a higher tax bracket.
To highlight this issue, assume that a 35-year old physician has $100,000 in a profit sharing plan, contributes $50,000 per year, earns a 6% rate of return and works for 30 years. Under this scenario, the physician would retire at age 65 with an account balance of just over $4,760,000, but not one dollar in this plan has ever been taxed. The deferred tax liability is enormous here, and if this money is required for retirement income, then our retiring physician may very well be in for a rude awakening when the tax bills come due each year. After all, Uncle Sam has been waiting patiently for 30 years for his share of tax revenue, and thanks to the income tax-deferred compounding, he is ready to get paid.
The purpose of this article is certainly not to discourage you from contributing to an investment account or putting money into your retirement plan (in fact, I usually encourage those that I work with to do both). However, I do want to shine a bright light on common financial planning strategies that seem to make great sense in general but tend to break down, if not cause harm, as time passes by.
By being aware today of the issues that compounding interest can present in the future, you can take steps to reduce taxation and increase your wealth and benefits down the road. There are a variety of strategies, which are beyond the scope of this article, that exist for the interest used on financial accounts. It simply takes the right game plan, an open mind and some discipline, and it certainly is no miracle.
Jeffrey W. Kirshner, CPA*, PFS, MBA
*Not Practicing for Guardian or any subsidiaries of affiliates thereof
The views and opinions expressed herein are solely that of the author and do not represent the views or opinions of The Guardian Life Insurance Company of America, or its subsidiaries or affiliates thereof
2017-48695 Exp 11/19