Einstein Was Wrong

Einstein reputedly said “Compound interest is the most powerful force in the universe.” I suppose it is possible that he said that, but I doubt it. Compound interest was not a point of discussion when Dr. Einstein was young and was barely considered by the time of his death in 1955.

It matters not if he said it. The statement is obviously wrong.

The most powerful force in the universe is compound taxation. Perhaps you have not heard of that. Let me explain.

If you pay income taxes, you are playing a two-person, zero sum game. In this form of game, player one wins what player two loses and vice-verso. In the tax game, the players are you and the government. Any part of the investment return you lose, they keep.

To understand the game you need to notice that when you pay income taxes, you give up two things.

  • Thing 1 – the money you send to clear your obligation, say 40% of what you earned. You know about that.
  • Thing 2 – 100% of the interest that money you sent could have earned. You do not normally notice that.

Suppose we examine this by looking at your account and also looking at another account that has your tax money in it and also earns income the same way that you do.

If interest rates are high or if you have a long time, Thing 2 will be vastly larger than Thing 1. You might want to build that idea into your plans. Loss avoidance is important. If you can avoid tax you get to keep both accounts. Like with a tax free savings account or life insurance.

For example, for each $1,000 invested when interest rates are 5% and the tax rate is 40%:

Account One

Account Two

Year

Earn

Pay

Have

Receive

Earn

Have

A

1

50

(20)

1,030

20

0

20

B

11

67

(27)

1,384

27

14

326

C

32

125

(50)

2,575

50

102

2,190

D

36

141

(56)

2,898

56

135

2,894

E

57

262

(105)

5,392

105

507

10,744

A As expected

B Year 11 Growth in Account A is less than Growth in B

C Year 32 Growth in A is one half of growth in B

D Year 36 Account A and Account B are equal

E Year 57 Account A is One half of Account B

Interest rates have typically been higher than they are now. Try it with 9% returns.

Account One

Account Two

Year

Earn

Pay

Have

Receive

Earn

Have

A

1

90

(36)

1,054

36

0

36

B

7

123

(49)

1,445

49

28

383

C

19

232

(93)

2,716

93

193

2,425

D

21

258

(103)

3,018

103

247

3,091

E

28

372

(149)

4,361

149

550

6,807

F

57

1,711

(685)

20,041

685

9,512

115,888

A As expected

B Year 7 Growth in Account A is less than Growth in B

C Year 19 Growth in A is one half of growth in B

D Year 21 Account A and Account B are equal

E Year 28 Growth in B is triple Growth in A

F Year 57 Account B is almost 6 times larger

Higher tax rates would matter but not as much as the rate and the time. At 9%, Account B is larger than Account A at year 57 with any tax rate over 14.7%

We can reasonably expect that returns will not stay low forever. Look again at the 9% example. In 28 years, you will keep accumulated income of $3,361 while the value of lost taxes is $6,807. If you are a 60 year old couple the odds are better than 50-50 that at least one of you will be alive in 28 years. Unless you intend to spend all your money before then, some of your investments are exposed to this scene.

Any drag on the yield your investments earn is very expensive over a long time and especially if rates are high.

Without tax management, no financial plan is optimal.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com