April 17, 2007

$1,000,000 After Taxes on Investment Growth

If I had a million dollars, we wouldn’t have to walk to the store.
If I had a million dollars, we’d take a limousine ’cause it costs more.
--- Barenaked Ladies, If I Had a Million Dollars

You know about compound interest. Or do you?

Let's use a simple example. Suppose you have a dollar. I'm sure you can imagine that. Now suppose that your investment grows 100% each year. That's a bit tougher to imagine, but it makes the numbers easier to follow.

Let's see how much you have after 20 years with and without tax.

Tax-free
Here's how your investment would grow:
  • end of year 1: $1 + 100% = $1 + $1 = $2
  • end of year 2: $2 + 100% = $2 + $2 = $4
  • end of year 3: $4 x 2 = $8
  • ...
  • end of year 20: ???
After 20 years, your dollar is worth is $1,048,576. Congratulations! You're a millionaire!

After-tax
Now suppose you pay tax of 35%, say. How much will you now have after 20 years? Pause and think about this. Here are the most common answers I get
(a) $1,048,576 - 35% = $681,574
(b) $1,048,576 - 65% = $340,787

The real answer is $22,370.66.



How can that be? Taxes compound just like growth. Here's how:
  • end of year 1: $1 + $1 x (1-35%) = $1.65
  • end of year 2: $1.65 + 1.65 x 0.65 = $2.72
  • end of year 3: $2.72 + $2.72 x 0.65 = $4.49
In just three years, $8 without tax becomes $4.49 after tax, a decrease of 44%.

After 20 years, you're left with less than $23,000. A tax of 35% led to a loss of $1,026,205. About 98% of the investment. Is that what you were expecting?

The Solution
Pick investments with high returns and no tax on the growth. Where can you find that combination? In universal life insurance. There are many investment choices. Growth is tax-sheltered (as in an RRSP). The insurance usually costs much less than the taxes you save.

By the way, if you know where to earn 100% annual returns, please post a comment.

9 comments:

Big Cajun Man said...

Pay Day Loan places charge 750% interest, so just start selling Pay Day Loans and you'll be richer even faster!

Yes, I know it isn't that funny is it?

--C8j

Promod said...

750% ?!?

I bet The Sopranos charge less than that --- and they're considered criminals.

Then again ... if you charge crazy interest rates, you'd be very wealthy when you're out of jail. Plus you get free room & board in the meantime :)

Thanks, big cajun man.

dj said...

Universal life? You can't be entirely serious. Can you?
Read "UL Blows"(google it). It might take more than one read for us Canadians to get past the hostility, but the math seems to stand up.
And sure enough, a review of my UL policy reveals a portfolio of Index funds with MERs of 3%. No typo. 3% MER on index funds. No choices.
Cheers,
Doug

Promod said...

Thanks for your post Doug. You may be surprised that universal life (UL) is an excellent choice in the right situations.

Yes, the general perceptions are negative. I'm very interested in understanding those concerns and providing a different point of view. My intent is to be unbiased. You can judge for yourself. This'll take more than one post :)

When googling, it's best to search for pages from Canada. Otherwise you'll mainly get US info, and their products differ greatly because of their tax system.

I've developed UL policies for a handful of companies over the years. Generally speaking, if the Management Expense Ratio is 3%, then there is a bonus/reward of some type, typically reducing the MER by 1.2%. So the effective MER is then around 1.8%. The investment choices do vary among companies. Companies invariably add new investments and do offer them to inforce policies unless systems limitations get in the way.

I hope you'll at least agree that no tax is better than some tax :)

dj said...

"UL is an excellent choice in the right situations"

Maybe we could start by listing those situations?

Promod said...

Hi Doug. You're back. I'm building a companion wiki at www.riscario.com that may give you answers for both personal and corporate situations.

Consider cars, pickup trucks and buses. Depending on the situation, one may be a better choice. The answer could even be "out of the box". Say, walking or biking.

It's the same with life insurance. As you may know, the main choices are term life, whole life and universal life. Each serves different needs. Some folks may benefit from one. Some from none. And no, I'm not suggesting we sit down and look at your situation ;)

I'll provide more information over time. You may find it convenient to sign up for updates by email, as my plan is one post a week. This is a hobby ...

Anonymous said...

promod,

does your calculation assume that you sell your gains each year? what if you keep your paper gains each year and then cash it all in at the end of the 20th year; wouldn't the gain be (a) $1,048,576 - 35% = $681,574?

Promod said...

You're correct, Anonymous. Losing 35% at the end of 20 years is still expensive :(

BrettBuen said...

I acquired a CP-11 letter in my mailbox and I did not see why the Internal Revenue Service is allowed to make modifications to my income tax which would leave me with a back tax debt due. I imagined these folks were simply just trying to get funds out of me and was going to head over to the courtroom regarding this until I discovered the calculation the Internal Revenue Service fixed. Review of your return often, and perhaps use a professional to look it over before you can make an attempt to dispute the IRS. http://www.tax-defense-network-cpnotices.com/cp-notice/47-2/