Taxable Compound Interest

A 30-year old person has $50,000 in a 6% C.D. in a Roth IRA account at a bank. Assuming a 40% marginal income tax bracket and the C.D. continues to earn the same interest, how much money will they have at age 65?

The person will have $287,175, and if they choose to cash it in at age 65, no income taxes because Roth IRA accounts are income tax free.

Another 30-year old person has $50,000 in a 6% C.D. in a tax deferred fixed annuity bought at his bank. Assuming a 40% marginal income tax bracket and the C.D. continues to earn the same interest, how much money will there be at age 65?

There will be $287,175, and if cashed at age 65, income taxes will be due, at the amount of $94,870 at that time. 

Another 30-year old person has $50,000 in a regular C.D. also earning 6% at his bank. They has selected to compound the interest in the account until age 65 without making any withdrawals. Assuming a 40% marginal income tax bracket and the C.D. continues to earn the same interest, how much money will there be at age 65?

There will be $287,175 in the account, the same as with the Roth IRA or the Traditional IRA at age 65. 

However, since the account's interest was not tax-free or tax-deferred, the person had to pay income taxes each and every year on the interest earned.  This person would have paid out-of-pocket income taxes to Uncle Sam in the amount of $94,870.

Although the three people above have the same amount of money at age 65, their costs to acquire the $287,175 in the account were quite different.

• The person with the Roth IRA faired the best with no income tax costs. 
• The person with the traditional IRA faired second best when he paid an income tax cost of  $94,870.
• The person with the regular C.D. who compounded his interest had the most cost. While he paid $94,870 in income taxes, they were not paid out in one sum at age 65. Rather, taxes were paid out incrementally each year as the interest was earned. Therefore, one must use the time value of money to calculate true costs. Assuming an after-tax investment rate of 6% for the time value of money purposes, this person loses $94,870 in taxes plus $111,896 in lost earnings on those taxes. In other words, if a person pays income taxes sooner than later, it has a higher cost. The cost of compounding the income taxes paid out over 30 years ($94,870) is actually $206,766 in this example.
• One may ask, what if the third person paid the income taxes from the regular CD account each year (netting) instead of compounding the interest? They would have faired better. The person would have $144,465 at age 65, but would also have avoided the time value of money cost of $206,766 that the person compounding the interest experienced. Therefore, of the four possible ways to accumulate long-term savings, tax free, tax deferred, and netting are all less costly than taxable compound interest.  This fact is generally true regardless of the interest rate and tax rate assumptions used. 

Our process may help you eliminate some or all of the financial costs associated with owning a taxable compound interest account while still maintaining its benefits. We use a unique cash flow money strategy to help accomplish these goals.

This is a hypothetical example and is not intended to suggest a particular course of action or represent the performance of any particular financial product or security. All investments contain risk and may lose value. 

Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.