Provide a side-by-side summary comparison between the different strategies. |
You will notice that all four positions have the same account values on the top. The thing to consider is how much it cost to get there. It is obvious that there is a great deal of wealth, which can be recaptured by avoiding the Compound Interest position. Remember compound interest is not the problem, its increasing tax. Since most people try to pay these taxes from their lifestyle, it can have a dramatic effect if these taxes can be avoided. The best thing to note here is that these changes can be made without incurring any additional expense. There are really two things we can do to avoid paying increasing tax on the Compound Interest besides changing the investment altogether. One would be to flatten the tax as we have discussed. Second would be to create a reducing tax position by removing not only the interest but some of the principal as well over time. These two alternatives have a little different philosophy from each other, which should be addressed. The flat tax position basically says that I like the investment vehicle I am in currently; I am just not fond of paying taxes. I am satisfied with the amount of risk and the rate of return I am earning and wish not to change my investment. I understand that I do not want to continue to compound my interest because of tax and wish to remove the interest earned each year, pay the tax, and find another place to park the remaining interest where I can compound my interest in a tax favorable environment. Many are in this position when they retire because they begin living off the interest, which is taxable (unless it is in a Roth IRA or other tax favored account already). Since their account is not getting larger from rolling the interest back over each year, the tax is now flattened. Unfortunately, they may have been able to have more for their retirement had they not compounded their tax burden through their saving years. The reducing tax position varies only slightly. This stance says I am not really that fond of the investment I am in currently, but for several reasons, I am not willing to move the entire lump sum today. I would feel more comfortable moving all the interest earned each year along with some of the principal because of the tax advantages. |
This screen presents a comparison of the methods discussed(Increasing, Immediate Pay down, Flattening, and Reducing). A column is presented for each of the above methods of paying tax. The top cell of each column always contains the value of an ideal investment. Since the investment is not ideal, the boxes between the top and bottom contain adjustments for taxes. The next to bottom box contains the ideal value less all the taxes. The bottom box contains the tax due, if any, on the tax deferred dollars. Click the documentation button to generate the supporting worksheets. |