“The power of compounding is so great that our first job as investors is to avoid anything that might short circuit it” – Ira Rothberg
Quite often I am asked what the benefit is of investing with an IRA account. A question that never ceases to surprise me. Simply put, tax deferral means you don’t have to give up a portion of your investment gains to Uncle Sam. Accordingly, without a reduction in your investment returns by having paying taxes, you are able to fully redeploy the original principal investment amount, plus any gains on investment, thus increasing your total investment buying power. Doing this multiple times over can result in increasing your account value much quicker.
Tax Treatment in Action
So it should be understood that IRA’s are great tools for retirement savings, but what exactly does tax deferral mean for you?
Well, let’s say you are offered an opportunity to invest $20,000 in a friends company which has the potential for high growth over the next few months. You accept and invest $10,000 from your personal savings, and $10,000 utilizing an IRA account. After four months’ time your friend issues a distribution to all who invested in the company. To your surprise, each of your 10K investments is now worth $60,000; $120,000 in total. While the return on investment for both is the same, the $50,000 gain on your personal investment would be taxed as capital gains thus reducing its total purchase power for future investments. The investment made by the IRA account on the other hand would be tax-deferred or completely tax-free (depending on the account type). That means that the $60,000 held in the retirement account could be redeployed fully, where the personal account money has been devalued due to the tax obligation on the investment gains. This cycle is expressed visually in the chart below.
While the above example has been exaggerated to make a point, it should be a clear that making tax deferred investments increases your ability to accumulate wealth quicker by allowing you to keep more of your money.
A more realistic example of this may be found below showing investments made over a period of 20 years. This chart represents the same investment made by two accounts, taxable and tax-deferred. Again, the initial investment amount was $10,000. The investment returns 12% annually and contributions in the amount of $3,000 are made to each of the investment accounts per year. This is also assuming a marginal tax rate of 25%.
With these assumptions, we can determine that the tax-deferred account has a future value of $312,620, and the taxable account has a future value of $209,524. That’s a difference of over $100,000! As you can see, tax deferred investment significantly increases your ability to grow your wealth quicker by keeping more of your earnings.