Understanding and Controlling Your Finances

Taxed and Non-taxed Compounding Calculator

Taxes can have a big effect on the amount of money that accumulates in an account, especially when money is left in an account for a long period of time. In a tax-sheltered account (for example, an IRA or 401 K account), you do not have to pay taxes on interest until you actually withdraw the interest from the account. Therefore you can earn interest on all of the interest you earn. In a normal account (a savings account, CD, etc.) you pay taxes on the interest each year. Therefore you earn less.

This calculator shows you how much money you can make by leaving a sum of money in an account at a certain interest rate. It helps you to understand the difference that tax-sheltered compounding can make, and in addition shows you the effect of inflation. Enter the amount of money that you wish to deposit initially, the expected interest rate, and the expected inflation rate. 

It is particularly interesting to note the massive difference between the taxed and non-taxed numbers after 20 or 30 years. There are several ways to save money that make use of completely tax free compounding:

1. in a 401(k) account
2. in an IRA account
3. by purchasing individual growth stocks that do not pay dividends or that reinvest dividends
4. by using certain types of annuities or life insurance

The inflation column shows you the effect of inflation on your initial deposit. For example, if you deposit $1,000 in an account and the inflation rate is 4%, then the value in the inflation column will be $1,040 after one year. This means that in one year it will take $1,040 to buy what costs you $1,000 to buy today. If your investments do not at least exceed the rate of inflation, you are losing money. If you look at the account value and it is less than the value in the inflation column over time, then your investment is actually losing money. Taxes often have that effect on lower-performing investments like savings accounts and CDs.