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The Power of Tax Deferred Compounding

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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