The Magic of Tax-Free Compounding

Highlights:

1. Tax-free compounding can make the very difficult task of saving for a secure retirement considerably easier
2. IRAs are an easy way to take advantage of tax-free compounding
3. Roth accounts enjoy unique tax breaks that can make them particularly magical.

"You control your destiny -- you don't need magic to do it.  And there are no magical shortcuts to solving your problems." -- Princess Merida of DunBroch (fictional character in the Disney movie “Brave”).

The illusions performed by uber-talented magicians, such as Lance Burton, can truly boggle the mind.  Even though the logical part of our brain knows that what we appear to see is an illusion attributable to sleight of hand or misdirection, our imaginations try to convince us that we are witnessing the supernatural.

For some of us, saving enough for a comfortable retirement can seem to require an act of wizardry.  In fact, according to a report by the Economic Policy Institute (EPI), half of all Americans have nothing set aside for retirement.  The financial demands of the here and now can turn saving for tomorrow into a near-supernatural feat. 

Fortunately, saving for retirement does not require magic.  Rather, consistent contributions to a qualified retirement account such as an IRA or a 401(k)’s can usually do the trick.  The reason: earnings on investments held in a retirement account compound tax-free and can be reinvested without being diminished by either capital gain or ordinary income taxes.  

The power of tax-free compounding (that is, reinvesting investment earnings pre-tax) is a feat even master magicians can’t top.  Albert Einstein is said to have referred to the magic of compounding as the most powerful force in the universe. 

Consider the following example:

Example 1

Penny Pincher opens an IRA on her 25^th birthday with a $6,000 contribution.  Each year thereafter Ms. Pincher contributes $6,000 to the IRA on her birthday to mark the occasion.  Penny retires on her 70^th birthday.  By the time Penny turns 70 she will have contributed $270,000 to her IRA.  However, through the magic of tax-free compounding, if Penny’s IRA grew by 7% a year, it would be worth $1,834,510.58.

Subject to a variety of limitations, in 2019 up to $19,000 (not including employee matching contributions) can be contributed to a 401(k) pre-tax, whereas up to $6,000 can be contributed to an IRA that is tax deductible.[1]  In addition, taxpayers who are over 50 can contribute an additional $6,000 to a 401(k), or an additional $1,000 to an IRA.  However, you can't contribute more than you earn to either a 401(k) or an IRA.

Distributions from qualified retirement accounts don’t have to start until the year after the account owner turns 70½, and thereafter can be stretched out over combined life expectancy of the account owner and the person who is to receive the amounts that remain in the account when the owner dies.[2]  As a result the near-miraculous benefits of tax-free compounding can continue well past retirement.

Perhaps the most magical of all qualified retirement accounts are Roth 401(k)s and Roth IRAs.  There are 3 tricks that only Roths can perform:

1.  While distributions from a traditional IRA or 401(k) are 100% taxable, distributions from a Roth IRA or a Roth 401(k) are entirely tax free

2.  Distributions from a Roth IRA are not required during the life of the person who has established it. As a result, the entire Roth IRA can continue to compound income tax free during the owner's lifetime.[3] 

3.  If the Roth is not needed for the account owner’s retirement it can provide loved ones with a tremendous inheritance.

A traditional IRA or 401(k) can be converted to a Roth IRA or a Roth 401(k).[4]  However, amounts transferred from a traditional IRA or 401(k) to a Roth are taxable in the year of the transfer.  In addition, contributions to a Roth are not tax deductible.  However, for many a Roth account nonetheless handily outperforms a conventional retirement account because (i) amounts earned inside a Roth account are never taxed, whereas income taxes on the earnings on a conventional IRA are taxed when distributed; and (ii) a much greater tax-free compounding is possible with a Roth IRA than a traditional retirement account because distributions are not required from a Roth during the account owner’s lifetime.

Example 2

Edie Money is single, age 65.  She has accumulated $500,000 in her IRA and is no longer contributing to it.  Assume that the investments in Edie's account generate a total return of 7% a year and that the money market account earns 3% interest.  Assume also that Edie names her niece Goldie as the beneficiary of her IRA and that Goldie is age 40 when Edie dies. 

At age 65 Edie converts her IRA to a Roth IRA, and withdraws the funds to pay the tax that results from the conversion from her money market account (thereby leaving more in the Roth to compound tax-free).  Edie does not withdraw any funds from the Roth IRA while she is alive.  Edie dies at age 85.  Under these circumstances, the Roth IRA would be worth approximately $1,900,000 at Edie's death!

Assume further that Goldie decides to withdraw the minimum amounts permissible from the Roth IRA until her death at age 70 and the Roth IRA continues to grow at 7%.  Goldie would receive tax free distributions from the Roth IRA totaling approximately $4,900,000 during her lifetime and the Roth IRA would have a balance of approximately $4,600,000 at Goldie's death, for a total of $9,500,000!  Now that’s quite a trick!

Now that we have considered the potential for real-world performance with tax-free compounding, let’s watch master magician Lance Burton’s Royal Variety Performance from 1989.  (Please ignore any pop ups that might appear during the video.)

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Andrew J. Willms, JD, LL.M.

[1]  Individuals who have income exceeding certain limits are prohibited from making tax deductible contributions to IRAs. 

[2]  If the beneficiary of your IRA is your spouse, he or she will be treated as being no less than 10 years younger than you when calculating RMDs.

[3] Distributions are required from Roth 401(k)’s after age 70 1/2.  However, they can be rolled into a Roth IRA, which is not subject to RMDs during the owner's lifetime.

[4]  There are no income limitations with respect to who can convert a traditional IRA to a Roth IRA.