Tax Deferred Compounding - Understanding Why Its Important

Growing your investments depends on the compounding rate. Einstein said, "The most powerful force in the universe is compound interest." The higher the rate, the faster your investment grows. But that's only half the story because you don't need to double the rate to earn twice as much. Increasing the rate from 6% to 8% will produce more than that 33% increase in your investment over the years as the table below indicates. That's the magic that amazed Einstein! And that's why tax-deferred investments are such an advantage. Let's take a look at some results...

Per Cent Greater Accumulation for 8% over 6% Compound Rates of $10,000


Year 6% 8% % more


5 13,382 14,693 10%

10 17,908 21,589 21%
15 23,966 31,722 32%
20 32,071 46,610 45%
25 42,919 68,485 60%

30 57,435 100,627 75%



Most investment choices generate interest or dividend earnings that are taxed annually. If your investment return is 10% and your income tax bracket is 28%, then 28% of that 10% (i.e. 2.8%) of that investment return goes to taxes. But what if we could defer the yearly taxation and give even more horsepower to Einstein's most powerful force? The ability to eliminate or defer taxes is critical for any investor.

This is critically important to retirees who may be interested in accumulating a larger next egg aside to purchase an immediate annuity in later years in case they live longer than the expected. The table shows the taxable earnings rate you must receive to achieve a compounding rate equal to the tax-deferred compounding rate based on various tax brackets.

Taxable Earning Need to Compound Equally to Tax-Deferred Earning


Federal Income Tax Brackets 10% 15% 25% 28% 33% 35%


Equivalent Taxable Earnings


Tax-Deferred Earnings 8% 8.89% 9.41% 10.67% 11.11% 11.94% 12.31%

7% 7.78% 8.24% 9.33% 9.72% 10.45% 10.77%

6% 6.67% 7.06% 8.00% 8.33% 8.96% 9.23%

5% 5.56% 5.88% 6.67% 6.94% 7.46% 7.69%

Want to put the power of tax deferred compounding to work in your portfolio? Just use the deferred annuity calculatorto see what can be accomplished.

Note that annuities once annuitized cannot be surrendered for value. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.

See more articles on maximizing your retirement income and retirement investing choices.

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