Tax Tip 154:The effect Tax has on Compounding of investments

The effect Tax has on Compounding of investments


I read on another forum that Tony Robbins used this great example to demonstrate the effect that tax can have on compounding. At first I did not believe it, so I made my own spreadsheet to test it out.


The example goes like this:

$1 doubled 20 times becomes $1mil, but
$1 doubled 20 times with 30% tax deducted each time only ends up becoming $40,000





This shows 2 things:

· The power of compounding and building a large capital base as quick as possible, and

· How taxes can hold you back, and therefore the importance of minimising them.


But keep in mind that it is not only taxes that will hold you back, but spending will also greatly limit your compounding. If you paid no tax but spent 30% of your income then a similar effect will happen.


I have attached my spreadsheet so you can play around with changing the tax amounts.

· 5% tax results in $631,000 in year 20

· 47% tax results in just $4,941 in year 20.

 

If you think tax has an effect the issue with neg gearing is even stronger and uses real cashflows whichg shows the power of leverage and time. The PIA software will demonstrate this and is why I really encourage people to invest inthe software and the time to use it. Its VERY technical but sells itself.

 

Are you suggesting that compounding works best in super as it is most tax effective - so it is worthy to be at least part of a diversified strategy.

When you are starting out most glossy brochures on expected average returns don't take into account your final position after tax while holding and when selling along with fees / expenses. Which can bite a lot compared to what you may were originally expecting or calculated.

 

If its +ve geared perhaps. I have many high wealth clinets who have bought property in super for the 10, 15 or 0% tax rate...and if its neg geared a higher marginal tax rate improves the tax outcomes v's a low income person.

If you reading a glossy brochure for property investment its probably worth walking away. None of these will ever show after tax outcomes.

 

Best to minimise taxes as much as possible so as to allow for more capital to compound quicker. Super often has a lower tax rate than a members marginal tax rate. But this doesn't necessarily mean super is the way to go as there are other considerations.

 

I look at it this way. If there were two investments, A and B, and:

• A produces 8% growth and 4% income
• B produces 4% growth and 8% income

Both produce a total gross return of 12% but A will make you financially independent quicker as there is no tax on the growth (until you sell) but you must pay tax on the income (after expenses) every year.

I wish BS and the ALP would understand this .