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POWER OF COMPOUNDING

TAX RATES

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Two golfers decided on a friendly bet -- $1 doubling for each successive hole. Neither had done the math, and both figured it was a reasonable wager that would not invoke spousal scorn. They soon realized, however, that the bet was much richer than they had imagined.

By the 12th hole, the bet was $2,048. They stopped and did the math, and calculated that the 18th hole would be worth $131,072! They also figured out that if one of them won every hole, he would win (and the other lost) $262,142!

How does compounding at a pre-tax, tax-deferred rate compare to compounding at a currently taxable, after-tax rate? Using the example above, assume that instead of increasing 100% for each hole, the bet increased only 50%. Even though the rate of growth is half, the amount of money one of them could have won on the 18th hole would be only $985, or 133 times less than if the growth rate were twice as much.

Real rates of return are much less, of course. But the relationship still holds. A 50% reduction in the accumulation rate (caused by current taxation), will produce a much greater erosion in capital accumulation. For example, a 10% return over 30 years will produce 4 times the accumulation of a 5% return.