Doing Your IRA Math
Tax-deferred growth is one of the greatest gifts the U.S. government has ever given its citizens. When you put money into a Traditional or a Roth IRA, you are not taxed on your gains while the money is still in your account. This gift allows you to fully take advantage of what Albert Einstein is credited with calling the 8th wonder of the world: compound interest.
Compound interest lets your money make you more money that then makes you even more money. For instance, if you have $100 and invest it for a year with a return of 10 percent, you will have $110 at the end of the first year. If you then invest that $110 for a year with a return of 10 percent, you will have $121 at the end of the second year. During the first year, you earned $10 in interest. But because you had more money to work for you at the end of the first year, you earned $11 in interest during the second year. That is the magic of compounding.
Letís take a look at how taxable growth crimps your compounding when compared to tax-deferred growth.
Imagine you have $200,000 to invest and you pay 25 percent in taxes each year. You place $100,000 in a taxable account earning 10 percent a year and $100,000 in a tax-deferred account earning 10 percent a year. At the end of 20 years, your results are dramatically different.
Using a taxable account, you will have $424,785 at the end of 20 years.
Using a tax-deferred account, you will have $672,750 at the end of 20 years.
Thatís a nearly $250,000 difference. You do the math. Would you rather have your money growing tax-deferred, or would you like to keep paying Uncle Sam on an annual basis?