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.
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: ???
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
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?
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.