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The
Power of Tax Deferred Compounding
Delaying, or deferring,
when you pay income tax on the earnings of an investment provides a means
to earn interest on your interest.
Ways to Defer Income
Taxes
The simplest ways to take advantage of tax deferral are with qualified
retirement plans (such as a 401(k) plan or with an IRA. For purposes of
discussing tax deferral, let us ignore the potential additional benefits
of any tax deduction you may get for contributions. Other ways to defer
taxes include annuity contracts and even with stock investments.
How Tax Deferral
Works
IRA contributions are the simplest to demonstrate. Let us compare the
difference between making $5000 annual contributions to an IRA with saving
the same amounts in a taxable savings account. We will assume that both
accounts earn 6% annually. For the savings account, the values are after
taxes of 28%.
|
Year
|
Total
Contributions
|
IRA
Value
|
Bank
Account Value
|
|
1
|
$5,000
|
$5,000
|
$5,000
|
|
2
|
$10,000
|
$10,300
|
$10,216
|
|
3
|
$15,000
|
$15,918
|
$15,657
|
|
4
|
$20,000
|
$21,873
|
$21,333
|
|
5
|
$25,000
|
$28,185
|
$27,255
|
|
10
|
$50,000
|
$65,904
|
$60,928
|
|
15
|
$75,000
|
$116,380
|
$102,532
|
|
20
|
$100,000
|
$183,928
|
$153,932
|
|
30
|
$150,000
|
$395,291
|
$295,895
|
|
Taxes
Due*
|
|
- $66,681
|
None
|
|
Net
After Tax
|
|
$326,610
|
$295,895
|
* Assumes contributions
to the IRA were not tax deductible and therefore taxes are only calculated
on the earnings when distributions are taken.
Why Tax Deferral
Works
Continuing to earn returns on funds that would have otherwise been paid
in taxes enables your funds to grow faster and to accumulate to a greater
amount. You should also know that the higher the earnings rate, the more
tax-deferral works to your benefit.
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