All Aboard! Taxes, Compound Interest and the IFR Train

All aboard taxes compound interest and the ifr train

Four of your financial planning clients board a train at the same location. Once on board they begin to talk and compare the cost of their tickets. The clients are shocked to discover that each of them had paid a different ticket price. The one who paid the most had no idea how expensive his trip was until he compared it to the others. Their tickets, all identical, were issued on the same day for the same trip. However, the total cost to reach the same destination was different for each.

How Much Does it Cost to Ride the IFR Train?

Most people are aware that their money will grow over time through the power of compound interest. And grow it does. However, most are unaware that if their money is in a taxable account, the taxes are increasing right along with the growth of the investment. The way your financial planning client chooses to handle that tax liability can have a significant impact on their circle of wealth.

There are four methods of paying the taxes:

  1. Increasing Tax: Continue to increase the taxable account and pay the taxes out of lifestyle. The account will continue to compound and the taxes will continue to increase.
  2. Immediate Pay Down: Move all the money into tax favored accounts.
  3. Flat Tax: Move only the earnings. Keep the principal in the taxable account. The taxable account remains the same and the tax-favored account continues to grow.
  4. Reducing Tax: Take a portion of the principal and interest and move it into tax-favored accounts. The taxable account decreases in value, and the tax-favored account continues to grow.

Your financial planning clients need to understand that regardless of which method they choose, the account balance at the end will be the same. However, the cost in accumulating that balance will be different under each of the four scenarios.

The passengers on the train are all headed to the same destination, but each has incurred a different cost in getting there. There is a cost to ride the train. The question is, “What are you willing to pay for your ticket?”

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