How to Explain Compound Interest to Your Clients: A Helpful Guide

There once was a blind man who was miraculously given his eyesight. For his entire life he had accomplished everything he needed to do without the benefit of eyesight. Instead of utilizing his vision, he leaned heavily on the use of his other senses.

When he was suddenly able to see, he had nothing to relate his new eyesight to. What was once familiar was now strange and complicated. He was seeing things for the very first time, and he did not know how to travel his daily path by sight. In the beginning, even with his repaired eyesight, he still relied heavily on all of his other senses to guide him.

So, what does all of this have to do with the Circle of Wealth®?

Your job as an advisor is to help your clients and prospects see things from a different perspective. Much of what you bring to the table, they are seeing for the very first time. Like the blind man adjusting to his newfound eyesight, your clients and prospects will also likely struggle with this new perspective.

As an advisor, the Circle of Wealth® will give your clients a clear view of compound interest.
As an advisor, the Circle of Wealth® will give your clients a clear view of compound interest.

Many people have the idea that growing their money by compounding the interest is the only way to significantly impact their wealth. They are completely unaware of the impact that transferred dollars can have on their wealth. They are blind to it.

Are you prepared to help your prospect see their present financial position in a way that they could not have imagined before they met you?

The Circle of Wealth® provides all of the tools you need to help your prospects and clients “see” differently than before. All you have to do is learn it and apply it. Keep reading for an example of how our system helps you explain compound interest to clients.

How to Start the Discussion About Compound Interest

Compound interest over time uninterrupted at reasonable rates can compare quite well to accounts that have potential for higher returns, but also brings the potential for loss into the equation. Follow the scripts and guides below for direction as you explain the potential returns and losses to your clients.

Simple vs. Compound Interest

Start by making sure those you’re advising understand simple interest vs. compound interest. As the script explains:

The basic assumption is that compound interest pays interest on previous earnings and simple interest only pays interest on the initial principal balance.


Typical View of Compound Interest

This is what compounding your money looks like. You start with a lump sum investment and each year your account grows as the interest is paid. Most people just roll the interest earned back into the investment account, which continues to add to the compounding effect.

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While the major focus is on the compounding interest, the increasing tax often goes unnoticed.

The government is a silent partner in this account. They take no risk, but participate in all the profits. While you are focusing on the interest, they are counting their returns. Your interest is compounding but so is the tax.

Compound Interest and Increasing Tax

Let's go through the years, watching the account grow on the left, which represents the money you have in your account.

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The account on the right represents the taxes, which you must pay in order to maintain the account on the left.

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What is your first reaction to seeing this happening to your account? Where are you getting the money to pay the taxes due each year earned on your investment account?

How People Pay The Tax

What do most people do with the interest they earn in their investment account? Most let it compound through re-investment. Very few people pay the taxes due on their investment from the interest earned in the investment. They roll the interest back into the account, which gives the appearance of the magical growth.

Where do they get the money to pay the additional taxes due from the investment? It usually comes from another source, which we are calling lifestyle. Most likely the taxes due from their investment results are included in their overall tax picture and go unnoticed for a while, which brings us to the next point.

In what year will the annual tax due be more than your annual contribution? In this example, the taxes would be $10,414 in year 22.

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If I can show you some opportunities which would allow you to avoid transferring those taxes to the government each year, it would have a dramatic impact on your Circle of Wealth.

Opportunity Cost of Tax

Do people pay more taxes than they have to? The obvious answer is yes, but not because they want to. Most people would prefer to avoid the tax if they knew of a way to do so, which could reduce their risk and at the same time give them more money, especially if it did not affect their lifestyle. Remember, if you pay a tax you could have avoided, you not only lose the tax dollar, but what that dollar could have earned for you had you not given it away. This is known as Opportunity Cost.

Increasing Tax Liability

This screen demonstrates the taxes paid, the cumulative taxes paid and the cumulative taxes paid with opportunity cost.

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Present Value of Taxes Paid

This screen calculates the present value of the taxes paid.

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The documentation proves that the lump sum present value of the taxes would be consumed over the time period by the taxes paid.

Hypothetical Tax Side Fund Consumption Illustration

This screen graphically illustrates the growth of the investment and the consumption of the lump sum (present value of taxes).


Summary Result Comparison

If you look at the graphic below, 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: it’s 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.

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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. 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 with your client.

The flat tax position basically says, “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.”

While you, as a financial advisor, understand the potential returns and losses that accompany compound interest, it can be challenging to clearly explain these principles to clients. Our Circle of Wealth® system provides all the tools you need to provide them with the details they need to make an informed decision. Contact us if you’d like to learn more about how our system can help!

About MoneyTrax:
MoneyTrax, Inc. was founded in 1994 by Don Blanton and has gained national recognition for its unique financial planning approach, intuitive client presentation software, advanced training, and effective marketing tools. Since inception, MoneyTrax, Inc. has helped thousands of financial advisors nationally better serve their clients by providing the tools and training necessary to educate and increase their client’s financial Circle of Wealth®. The Circle of Wealth® system significantly expands the financial advice available to a family beyond the industry accepted approach used by most advisors today. Click here to learn more.

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