Q: What is the reason for using tax shelters? The government is going to tax you when you take the money out, so what is the benefit?

A: One commonly misunderstood financial principal is the importance of deferred taxation. Some people figure that since taxation is inevitable there is no point worrying about whether you pay the taxes now or later.

Mathematically speaking, this is far from true. The more assets you have available to compound, the greater your total returns. Taxation erodes your asset base leaving you less money available for growth.

This principal is illustrated below:

Tom, Richard and Harry are triplets. Their parents taught them the importance of planning for their financial futures. For this reason they all began to invest $1000 per month from age 25 until they retired at age 65. Their investments all returned a net average of 12% per annum, and all three men have a marginal tax rate of 40%.

Tom invested his money without consideration for taxes. He paid 40% capital gains tax on the growth of his investments annually. At the end of 40 years his total savings came to $2,776,938, which he thought was pretty good.

Richard invested his money using a tax shelter. When he retired he removed his assets from the shelter and placed them in a bank account paying 5% per annum. He was hit with 40% capital gains tax, but his total deposit amounted to $7,730,863.

Harry invested his money using a tax shelter. When he retired he kept his assets within the shelter and lowered his risk with secure assets paying 5% per annum. His total amount on retiring came to $11,284,772. He plans remove funds from the shelter as he needs them. He will be taxed on the sums removed, but the remaining balance will continue to grow tax free.

Growing your assets tax free until you actually need them can be very efficient if you have a long-term investing horizon. The difference in total amounts available to you when it is time to retire can make an enormous difference in the quality of your retirement years.

Money Matter Q&A