Updated: Oct 15, 2020
Albert Einstein defined the 8th wonder of the world: Compound Interest.
He further states: "He who understands it, earns it. He who doesn't, pays it."
I've got one minor correction to make to Einstein's statement: Uninterrupted compound interest is the 8th wonder of the world. I'll expound on that later.
But my question to you is this: Do you believe the Government knows this?
What happens when you earn interest in a taxable account? You are taxed on it.
What happens when you have a capital gain in a taxable account? You are taxed on it.
You are successfully doing things to enhance your own situation... and you are TAXED for doing whatever you do successfully.
Reagan is right about Government's view of the economy: "If it moves, tax it."
But does your advisor know this? Of course your advisor knows this... or do they?
Every financial calculator has an IRR button on it to calculate an "Internal Rate of Return". Let me give you an example.
To calculate the internal rate of return on a given sum of money (let's say $50,000 for this example) to DOUBLE in 10 years to $100,000... what rate of return do we need to earn?
PV (Present Value): = - $50,000 (it's negative because we are taking it out of our pocket). FV (Future Value): = $100,000 n (number of years): = 10
PMT (payments): = 0 (we're not adding in any additional contributions)
Press 'i' to solve: 7.18% per year
(Of course, this exercise is really just the "rule of 72" in action.)
But what did this calculation OMIT? Any annual TAXES or any other EXTERNAL COSTS being factored in!
If we TAXED the growth at let's say 30% each year (or reduced the internal rate of return by 30% or 2.15 to 5.03%), how long would it take to double our money now?
It would take 15 years, or 50% LONGER to double our money when we account for taxes!!!
Does that bother you? Does it bother you to know that by doing what YOU can to plan for your future, that YOU have to pay more in taxes for everything that you do successfully? And because of that, YOU have to have your plans SLOWED because of these taxes and other external factors??
Taxes are just ONE factor in an "external rate of return" calculation.
What's an "External Rate of Return"? There isn't an official definition that I could point to, but essentially, it's a NET rate of return or a NET distribution AFTER all the external factors are factored in.
What kinds of external factors? What External Wealth Eroding Factors can affect your wealth building AND (most especially) your wealth distribution plan in retirement?
Federal income taxes
State income taxes (depending on your state)
Taxation of Your Social Security Retirement Income Benefits
Additional costs of your Medicare premiums (IRMAA)
Investment fees to put your capital at risk so you can have the money to pay the above.
You are paid SIXTH in line.
Does that bother you? Does it bother you that YOU have to take on the additional investment risk in order to pay all these people in line before YOU get paid from these accounts?
Is your advisor just focusing on growing the biggest pot of money for you - virtually IGNORING the tax consequences on the upside AS WELL as the distribution side of wealth?
Or are they only focused on "Internal Rate of Return" being the solution to everything? While compound interest is great using a financial calculator... the NET result is what we are really needing and wanting from the advice we are seeking.
Let me ask you this question: Which account would you rather have:
A) $5,000,000 B) $3,000,000 Our first instinct is to say we want "A" - the bigger account.
Here's the second part of the question: Which account would you rather have in retirement: A) $5,000,000 with a 3% distribution rate for $200,000 FULLY TAXABLE B) $3,000,000 with a 6% distribution rate for $180,000 TAX EXEMPT Which would you rather have now?
What good is it to have $5 million in an account where it is subject to all the wealth eroding factors... when you can actually have LESS money in a different account and have it essentially "off the radar of the Internal Revenue Service"?
Here's another few questions to ponder:
Isn't our Government hurting for money right now?
Do you think the Government knows that there are accounts like this that exist in the tax code?
How long do you think they'll allow these accounts to be sold the same way under the current tax laws?
If they affect the tax code of these accounts, won't they let the current accounts work the same way as they have before they enact the new laws - just as they did back in the 1980's - the last time they affected the tax laws?
If that's the case, won't the people who already have these accounts be the ones allowed to keep them?
If that's what is possible... would you rather get YOUR plan in place BEFORE or AFTER the Government decides to change the taxation laws on these accounts?