E26: Interest hikes like the 80’s? The power of Tax Deferral

Interest hikes like the 80’s? Power of Tax Deferral and the $400k mistake you may be making!

In this episode, Tyler breaks down the tough task ahead of the fed when it comes to interest rate hikes and inflation. Additionally, he examines the power of tax deferral and a 400k mistake you might be making.

Inflation

If you have filled up your car or made a grocery run lately, you are probably very aware that prices have skyrocketed. We have covered some of the reasons for this in past episodes but how do we fix it? Well, the best way for the fed to control inflation is to raise interest rates. Let’s break down why that is the case. When the pandemic hit, the fed dropped interest rates to historic lows. This was to make money very accessible and cheap within the economic system and help keep the economy moving through shutdowns and disruptions. Essentially, the fed wanted to flood the economy with money. When that happens, inflation can begin to pick up and we started to see that happening in 2021. To help control the problem the fed can reverse the process and raise rates to make money harder to access and more expensive to borrow. This will reduce the amount of money in the economy and help drag down inflation.

We have seen the fed do this many times throughout its history but one of the closest comparisons would be in the late 70’s. We saw a large uptick in inflation and the fed took a policy to reign it in by persistently raising interest rates until it was under control. This policy led rates to hit a high of 20%! While it did end up reducing inflation, the contraction on the economy lead to the recession of 81’ and 82’. This is the big problem that the fed is up against today. They need to raise rates fast enough to make sure inflation does not get out of control but not so fast or aggressively that they push the economy into a recession. Right now everyone wants inflation to come back down to earth, but they don’t want the economy to stall or the market to fall…. Unfortunately, those two things work against each other. Let’s hope that the fed has learned the lessons from the 70’s and can land this plane softly. However, the task is going to be incredibly difficult to accomplish.

Tax Deferral

Why is tax deferral so important? Well, let’s start with what tax deferral is – Tax deferral is when you invest in a qualified account (think of your 401k) where any gains in the account are not taxed until you take money out down the road. This means any interest, dividends or capital gains do not receive any taxation in the year they happen but instead is deferred until the money is withdrawn.

If we take two investors and have them invest 100k earning an average of 8% for 20 years into a taxable account and a deferred account, we will see that the deferred account earns 52% more growth than the taxable account. This happens because every year the deferred account allows all the money to remain in the account instead of having to remove some to pay taxes on any gains. That extra money remaining in the account can continue to grow and earn interest and ultimately leave the deferred account in a better position. Understanding the power of this can go a long way to helping you maximize your investment returns!

400k Mistake

Tyler talks about how waiting to invest can have a substantial impact on your long-term plans. To highlight this, we can look at two investors. The first investor puts 6k into a IRA from age 22 to age 32 and stops. Only 10 years of putting money in and earns an average of 8%. The other investor invests 6k a year in an IRA from age 32 to 65. 33 years of contributing money and earning 8%. We will see that when both investors reach the age of 65 that the first investor who only contributed for 10 years has 400k more in their account than the investor who contributed for 33 years. How? Well, the first investor had the benefit of time on their side and while they were not contributing after age 32, the money was able to grow for 43 years instead of the 33 years for the second investor. Compounding interest will favor time in the market! If you are considering investing, know that every day you wait could be costing you big time!

DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security.