How Taxes Affect Your Compounding Interest Explained (Impact of Taxes and Compounding)

How Taxes Affect Your Compounding
Taxes and compounding.

How do taxes affect your compounding interest? To shelter your savings from taxation while building your nest egg is extremely important and you better understand taxes and compounding. I believe this is pretty obvious for most investors, but I suspect it’s still neglected because the headwind takes about ten years to really make a difference.

In this article, we look at how taxes affect your compounding interest. Unfortunately, taxes make your pension much smaller than it otherwise would do. Having a tax-deferred account is essential for letting your capital compound efficiently.  

Most investors ignore taxes, but over many years taxes are a serious headwind that makes your compounding inefficient.

Taxes and death are inevitable

For example, if you DRIP and reinvest your dividends, they are still taxable. The only way to defer taxes is via a tax-deferred investment account. For dividend investing, a tax-deferred account is an absolute must!

Unless you have a tax-sheltered account, you will take a beating whenever you receive a dividend or sell a profitable position. Most countries offer some form of tax-sheltered accounts and you should use them to your full benefit.

An example: How do taxes affect your investments?

Let’s look at two examples where you need to pay taxes:

Example 1: How taxes eat your investments – capital gains tax

The graph below illustrates a 50 000 account compounding at 9% for 40 years:

How do taxes affect your investments?
The effects of taxes in a compounding account.

The blue line is 9% compounded for 40 years without taxes, while the pink line subtracts 25% taxes on unrealized gains every year. By delaying taxes, you more than double your wealth. Quite a difference!

The tax scenario is a bit unrealistic because unrealized capital gains are not taxed, so let’s change the circumstances a bit:

Example 2: Capital gains taxes reduce your compounding – capital gains tax

Let’s assume you own shares in Microsoft worth 25 000 with a cost price of only 5 000. You have turned bearish on Microsoft and would like to switch to Berkshire shares, but unfortunately, the shares are in a taxable account. You estimate Microsoft can only compound at 8% over the next decade, while Berkshire’s can compound at 12%.

A switch to Microsoft needs to consider the effect of the tax rate of 30%. If you sell Microsoft, you will only have 19 000 to reinvest because of 6 000 in taxes (20 000 x 30%). If your future estimated returns are correct, the alternatives are like this:

  Value today Value in 10 years CAGR
Microsoft 25 000 54 000 8%
Berkshire 19 000 59 000 12%

This means you are better off switching to Berkshire instead of Microsoft. The alternatives are equal if Microsoft compounds at 9%. In other words:

The tax equals a 3% annual “penalty” over a ten-year period.

This is a perfect example of how taxes affect your investments and eat into your pension. If you don’t have a tax-deferred account, you should consider mutual funds (they are automatically tax-deferred until you sell or realize the profits).

Taxes on dividends (reduce your compounding)

Taxable dividends face the same challenge. The graph below shows 1 000 shares in VNQ purchased in early 2005 (56 750 USD) and held until September 2019:

Taxes and dividends
Dividend reinvestment in VNQ. The tax rate is 20%.

The blue line is reinvested dividends without taxes, while the pink line is the same dividend less 20% taxes. A no-tax scenario compounds the value to 182 000 USD, while only 159 000 subtracted 20% taxes. The difference in CAGR is 8.07% versus 7.12%.

As a rule of thumb, a company that pays a dividend that is “average” reduces its CAGR by about 1% annually. It doesn’t sound much, but over time it adds up.

How taxes affect your compounding interest – conclusion:

You face severe headwinds if you keep your stocks in a taxable account and the drag compounds over long time horizons. A 1% annual difference amounts to a much smaller nest egg for your retirement.

If you still have a long runway until you retire, you must make sure you defer all the taxes you can. This article has shown you how taxes affect your compounding interest, and it clearly matters if you pay taxes now or later!

FAQ:

How do taxes affect your compounding interest?

Taxes can significantly impact your compounding interest by reducing the amount of money you can reinvest, ultimately diminishing your wealth accumulation over time.

– Why is it important to understand taxes and compounding when building your nest egg?

Understanding taxes and compounding is crucial because they can either help your wealth grow efficiently or act as a headwind that makes your pension smaller than it should be.

– What is the role of a tax-deferred account in wealth building?

A tax-deferred account is essential for allowing your capital to compound efficiently. It helps you defer taxes to a later date, allowing your investments to grow more effectively.

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