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The Power of Tax Deferred Compounding

Delaying, or deferring, when you pay income tax on the earnings of an investment has always provided a means to earn interest on your interest. The coming reduction in income tax rates can make this concept even more powerful.

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 with an IRA. For purposes of discussing tax deferral, let us ignore the potential additional benefits of any tax deduction you may get for contributions. Other ways to defer taxes include annuity contracts and even with stock investments.

How Tax Deferral Works
IRA contributions are the simplest to demonstrate. Let us compare the difference between making $3000 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%.

Year
Total Contributions
IRA Value
Savings Account Value
1
$3,000
$3,000
$3,000
2
$6,000
$6,180
$6,129
3
$9,000
$9,551
$9,394
4
$12,000
$13,124
$12,800
5
$15,000
$16,911
$16,353
6
$18,000
$20,926
$23,926
7
$21,000
$25,182
$23,926
8
$24,000
$29,692
$27,959
9
$27,000
$34,474
$32,168
10
$30,000
$39,542
$36,557
15
$45,000
$69,828
$61,519
20
$60,000
$110,357
$92,359
30
$90,000
$237,175
$177,537
Taxes Due
- $41,209
None
Net After Taxes
$195,966
$177,537

Tax Deferral Works
Continuing to earn returns on funds that would have otherwise been paid in taxes enables your funds to grow faster and to accumulate to a greater amount. This chart reflects the income tax rates to be in effect as a result of the 2001 and 2003 Tax Laws. You should also know that the higher the earnings rate, the more tax deferral works to your benefit.

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