The Amazing Properties of Compound Interest

The Amazing Properties of Compound Interest

I would like you to attempt an experiment with me.  Go and find a single piece of standard copy paper.  Now, take the piece of paper and fold it in half.  It does not matter if you fold it lengthwise, or cross wise.  Imagine that paper as a stack.  You now have a stack of 2 pieces thick.  The single piece of paper has been compounded into two pieces.  This is an example of how compound interest works.  Please fold that piece of paper again in half and then once more in half.  You should have folded the paper three times now.  Your stack of paper is getting a little thicker.  It should have become eight layers thick now.  If you unfold the paper, you can verify this easily by counting the folded sections and seeing that there are indeed eight sections.

Now I want you to be able to fold that piece of paper so thick, that it will stretch past the sun.  It is really quite simple and takes nearly no time.  Just fold the piece of paper in half a total of 50 times.  If you are like me, after you get to about six or seven folds, it is too difficult to fold any more.  But let us imagine that it was possible to continue to fold the paper.  When we do the math, the sheet of 20lb copy paper has a thickness of about 0.1 mm.  By using compounding, the paper will double in sheets (and thickness) with every fold.  If you could count that high, you would have folded that single piece of paper into 1,125,899,906,842,624 pieces.  Wow!  By using compounding, this would equal a thickness of 69.96 million miles.  If you fold it just once more (51 times) you would pass the sun and it would take you over 15 minutes traveling at the speed of light just to reach the top of the stack.  (http://mathworld.wolfram.com/Folding.htm)

This same concept works with our money.  When we invest our money, we expect to get a rate of return on our investment.  After a full year of investing the money, we receive the full amount of interest promised, and if we leave both the interest we received and the original principal amount invested in the investment account, we get to experience the full power of compounding.  It would be hard to get a rate as great as 100% like in our example of paper folding, but I would like you to imagine that you could for the following example. The chart below will show what would happen if you started with only $1 and you were able to get 100% annual compounded return on your money.  

 

$1 Compounding With a 100% Annual Return
Year	Amount Invested	Interest Earned	Total Account Value
1	$1.00	$1.00	$2.00
2		$2.00	$4.00
3		$4.00	$8.00
4		$8.00	$16.00
5		$16.00	$32.00
6		$32.00	$64.00
7		$64.00	$128.00
8		$128.00	$256.00
9		$256.00	$512.00
10		$512.00	$1,024.00
11		$1,024.00	$2,048.00
12		$2,048.00	$4,096.00
13		$4,096.00	$8,192.00
14		$8,192.00	$16,384.00
15		$16,384.00	$32,768.00

After 15 years, that $1 would grow into an astonishing $32,768.00!  If you are in a money market account or certificate of deposit (CD) account or similar place, Uncle Sam will ask you for his share every single year.  The following is a chart showing the effects of taxes on your invested money you are in a 30% tax bracket.

$1 Compounding With a 100% Annual Return and Taxed at 30%
Year	Amount Invested	Interest Earned	Taxes on Interest Earned	Total Account Value
1	$1.00	$1.00	$0.30	$1.70
2	$0.00	$1.70	$0.51	$2.89
3	$0.00	$2.89	$0.87	$4.91
4	$0.00	$4.91	$1.47	$8.35
5	$0.00	$8.35	$2.51	$14.20
6	$0.00	$14.20	$4.26	$24.14
7	$0.00	$24.14	$7.24	$41.03
8	$0.00	$41.03	$12.31	$69.76
9	$0.00	$69.76	$20.93	$118.59
10	$0.00	$118.59	$35.58	$201.60
11	$0.00	$201.60	$60.48	$342.72
12	$0.00	$342.72	$102.82	$582.62
13	$0.00	$582.62	$174.79	$990.46
14	$0.00	$990.46	$297.14	$1,683.78
15	$0.00	$1,683.78	$505.13	$2,862.42

Unbelievable! There is nearly a $30,000 difference between letting your money grow without it being taxed along the way and letting it get taxed (and paying it from the investment account) every year.  Compounding always works best if you do not have to pay taxes on the profits along the way.  There are certain types of accounts that the government does not force you pay taxes as your money grows.  These accounts are called qualified accounts.  There are government restrictions on the amounts you are allowed to put into these accounts every year.  Some examples are 401(k), 503(b), IRA or Roth IRA accounts.  These all have different advantages and disadvantages.  There are also other, perfectly legal, but often underutilized strategies that do not have the limits on contribution amounts that the qualified plans have and allow your money to grow tax-free.  These accounts even let you live off the money tax-free in retirement (or sooner) as well!  This is accomplished by utilizing section 72(e) and section 7702 of the IRS code to achieve tax-free amortized growth in addition to tax-free loans from this account (without being forced to pay the loans back.)  This strategy has been used by the ultra wealthy for generations, but you can also achieve the investing results of these little know in often misunderstood strategies.  Contact us today before it is too late!

Jeff DeMonbrun is the Chief Operating Officer of Ironclad Wealth Strategies, a wealth advisory company that specializes in helping their clients eliminate risk and save money using little known wealth strategies.  Learn more at www.ironcladwealth.com.