The Power of Tax-Deferred Compounding
In this hypothetical illustration, we’ll analyze the scenario for a monthly contribution of $250 into a tax-deferred retirement account that is earning 8% APR versus the same monthly contribution and earnings rate in a taxable investment with a 25% tax rate.
This hypothetical example is not intended to illustrate the performance of an actual investment.
This illustration is not an indication or guarantee of future performance. The illustration is a
hypothetical analysis that is calculated using a single compounded rate of return, which is highly
unlikely as rates will vary over time, particularly for long-term investments. The illustration does
not take into consideration any investment fees or expenses, which would lower performance.
A taxpayer saving in a taxable investment would first have to pay tax on the $250 earmarked for saving, netting only $187.50 for deposit each month. In 10 years, the taxable investment would have grown to $30,970 while the tax-deferred retirement account would be at $34,531, net after taxes—a difference of $3,561.
Over a period of 30 years, the difference is even more dramatic. Here the taxable investment grows to just $191,250 while the tax-deferred investment grows to $281,305 net after taxes. The difference is a whopping $90,055!
The difference is that in the taxable investment, taxes were paid on all of the gains, thus reducing the amount saved. With the tax-deferred investment, all the funds that were paid out from the taxable investment to cover the taxes were allowed to remain in the account to compound over all those years.
1Many investors contribute to a traditional IRA in addition to an employer-sponsored retirement plan, although contributions may not be deductible due to their active participant status in their employer’s plan. However, the power of tax-deferral still applies to any earnings in the account. Contributions to Roth accounts are made with after-tax dollars.
2A 10% penalty may apply for early withdrawal (before age 59½).
Legend Equities Corporation and its affiliates do not provide tax or legal information or advice.