When is compounding interest NOT in your best interest?
Updated: Oct 26, 2021
In the world of financial advice, this would sound like heresy. Why would anyone NOT want compound interest on their wealth? Wasn't Albert Einstein right? "Compound interest is the 8th wonder of the world. He who understands it, earns it ... he who doesn't... pays it." So, when would compound interest be a bad thing? When you're compounding a tax liability at a rate you cannot yet calculate. Here's what I mean:
Let's suppose that you have 100% of your wealth in a 401(k) or IRA plan. (That's actually impossible, but go with me on this.)
Let's suppose that you are very successful in growing your account and it's now worth $1 million.
You want to take out a modest amount of 5% per year... or $50,000 - regardless of the growth of the account.
What will happen?
The $50,000 is subject to federal taxation because of WHERE the money grew and lives (in an IRS regulated retirement plan) that postponed its taxation (and tax calculations) to a future date.
Depending on your state, the $50,000 is subject to state taxation as well. Check on your state taxes for this. You may even pay local city and/or county taxes too.
That $50,000 will cause your Social Security benefits to become included in your taxable income at the 85% level. So, if you have $50,000 of Social Security, $42,500 is now taxable and *may* even cause you to be 'bumped' into a higher tax bracket! (For 2021 when I'm writing this, this is still in the 12% federal tax bracket, but tax brackets and rates can change.)
You may decide you don't need much out of your plan? In that case, Required Minimum Distributions (that now begin at age 72) will make sure that you have to take out an increasing amount each year throughout your retirement.
Upon your passing, your beneficiaries who inherit your plan, will pay taxes upon the distribution... at THEIR tax rates (while working).
Now, that was an IRS regulated retirement plan scenario.
Let's take a look at a non-qualified annuity plan scenario:
Let's assume you have a more modest account: $500,000. Perhaps from the sale of a house or an inheritance?
Let's assume it has a contract interest rate of 3%. This can be a fixed indexed annuity contract that may have 0% in various years, etc. I just want to show how it will be affected.
Let's compare primarily spending interest only vs a spend down.
Interest only: Assuming 3% per year and not touching the principle, $500,000 would earn 3% or $15,000 would be completely taxable each and every year.
Now, is that so bad?
You'd have to pay taxes on it (10% federal; 2% California state taxes).
We don't know how long these tax rates would last though, right?
Social Security wouldn't be touched by that withdrawal.
It's not terrible. But it's not tax sensitive.
The Spend down: What if we did a spend-down from this asset to purchase another asset to borrow against for our retirement cash flow? This would take a bit more calculations, but the biggest benefits are:
The life insurance wealth contract would multiply your inheritable wealth.
Loan distributions would be tax-exempt and immune from changes in the tax code, which would bring more predictability in retirement cash flow. (Based on past precedence of grandfathering past contracts before a change in the laws in 1986 or so.)
The life insurance wealth contract would have chronic illness benefits that the annuity may not have. (I'm in California, so these vary by state. California doesn't offer these provisions much due to state health privacy laws, etc.)
Will YOU be the primary beneficiary of these funds? The spend down can be SPLIT between taking income today AND doing a capital asset transfer for tomorrow! If you're just doing interest only... someone ELSE will benefit more than you will.
So take a look at where you're compounding your interest and what it may cost you. From my own calculations, your money can spend far better in a life insurance wealth contract than in an annuity. I use annuities to guarantee the principal and the funding of the life insurance wealth contract, not necessarily for their other features.
One prominent agent says this about annuities: "[Lifetime income] annuities are a guaranteed way to be screwed by the IRS every year." I believe that, for Californians, the combination of policies is a fantastic retirement strategy. However, be sure to review an analysis so you know how these contract combinations directly benefit you.
I almost forgot: What about the Standard Deduction?
For 2021, the standard deduction for Married Filing Jointly is $25,100. So if that annuity interest was the ONLY taxable item, they wouldn't need to pay any taxes on it. However, the standard deduction for filing SINGLE is $12,550 (half). So that annuity interest would create a taxable event if it wasn't coming from a tax-exempt source. True, it certainly wouldn't devastate you by any means, but why pay a tax if you know how you can avoid it? There's an old phrase that I like: "Gambling is a voluntary tax on people who are bad at math." I wonder if I should rephrase it to "The tax system in retirement is a voluntary tax on people who are bad at tax planning."?