The Power of Tax-Deferred Compounding

Delaying, or deferring, when you pay income tax on the earnings of an investment provides a means to "earn interest on your interest."

Ways to Defer Income Taxes

The simplest ways to take advantage of tax deferral are with qualified retirement plans, such as a 401(k) plan or an IRA. For purposes of discussing tax deferral, let's ignore the potential additional benefits of any tax deduction you may get for contributing to these plans. Other ways to defer taxes include annuity contracts and even with stock investments.

How Tax Deferral Works

Did You Know?

All in all, most Americans end up paying from one-fifth to one-half of their income on some governmental body.

IRA contributions are the simplest to demonstrate. Let's compare the difference between making non-deductible $5,000 annual contributions to an IRA with saving the same amounts in a taxable savings account. We will assume that both accounts earn 6% annually. For the savings account, the values are after taxes of 28% with distributions from the IRA being taxed when distributed.

Year Total Contributions IRA Value Savings Account Value
Year 
Total Contributions 

$5,000 

IRA Value 

$5,000 

Savings Account Value

$5,000

Year 
Total Contributions 

$10,000 

IRA Value 

$10,300 

Savings Account Value

$10,216

Year 
3
Total Contributions 

 $15,000 

IRA Value 

$15,918 

Savings Account Value

$15,657

Year 
Total Contributions 

$20,000 

IRA Value 

$21,873 

Savings Account Value

$21,333

Year 
Total Contributions 

$25,000 

IRA Value 

$28,185 

Savings Account Value

$27,255

Year 
Total Contributions 

$30,000 

IRA Value 

$34,877 

Savings Account Value

$33,432

Year 
Total Contributions 

$35,000

IRA Value 

 $41,969 

Savings Account Value

$39,877

Year 
Total Contributions 

$40,000 

IRA Value 

$49,487 

Savings Account Value

$46,599

Year 
9
Total Contributions 

 $45,000 

IRA Value 

$57,457 

Savings Account Value

$53,612

Year 
10 
Total Contributions 

$50,000 

IRA Value 

$65,904 

Savings Account Value

$60,928

Year 
15 
Total Contributions 

$75,000 

IRA Value 

$116,380 

Savings Account Value

$102,532

Year 
20 
Total Contributions 

$100,000 

IRA Value 

$183,928 

Savings Account Value

$153,932

Year 
30 
Total Contributions 

$150,000 

IRA Value 

$395,291 

Savings Account Value

$295,895

Year 
Taxes Due1
Total Contributions 
IRA Value 

-$68,681 

Savings Account Value

None

Year 
Net After Tax 
Total Contributions 
IRA Value 

$326,610 

Savings Account Value

$295,895

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