FINANCIAL FOCUS: PUT TRIPLE COMPOUNDING OF INTEREST TO WORK FOR YOU

This "Financial Focus" column is prepared by Edward Jones Investments, headquartered in St. Louis. Jones includes branches throughout the nation, including Cape Girardeau and Jackson.

Someone once asked Albert Einstein what was the most amazing discovery he had ever encountered. Without hesitation, he replied, "Compound interest."Of course, you don't have to be a scientific genius to appreciate the "miracle" of compounding. The ability of money to grow over times has benefited anyone who has ever saved for a goal.

Let's see how compounding works. Suppose you put $100 in an investment that earns a fixed 10 percent rate of interest. At the end of the first year, you will have $110. After two years, you will have $121. The extra dollar, which was earned on the $10 interest from the first year, is the compounded interest. (This example shows interest compounded annually; interest can also be compounded daily, quarterly or semiannually.)Earning compound interest is obviously a good thing, but it won't help you escape the tax man. In the above example, you would pay $3.71 in taxes on your $10 interest the first year, $7.79 on your $21 interest the second year, and so on, assuming you had a combined state and federal tax rate of 37.1 percent. If you withdrew this amount each year to pay taxes, you would be left with considerably fewer dollars to compound.

What's the alternative? You might want to put the same amount of money in a tax-deferred investment, such as an annuity. With a tax-deferred vehicle, you pay no taxes on your earnings until withdrawal. By investing in an annuity or other tax-deferred product, you can benefit from "triple compounding." First, you'll earn interest on your principal. Second, you'll earn interest on your earnings. And third, you'll earn interest on money that would normally have been lost to taxes.

Over time, the benefits of triple compounding can add up. Suppose, for example, that you invest $50,000 in an annuity that earns 8 percent each year. After 30 years, your initial $50,000 investment will have grown to $503,133. Conversely, if you had put the same $50,000 in an investment on which you paid taxes every year, your money would only have grown to $218,082 after 30 years, assuming an 8 percent annual rate of return and a combined state and federal tax rate of 37.1 percent.

You will eventually have to pay taxes on your earnings when you start making withdrawals. However, by that time, you may be retired and in a lower tax bracket. Or you may be able to structure your annuity payouts in a way that will reduce your tax burden. Even if you took your annuity as a lump sum, you would end up with an after-tax amount of $335,020 after 30 years nearly $117,000 more than you would have accumulated on an investment that wasn't tax-deferred.

Before you purchase any annuity, you will want to make sure the issuer, typically an insurance company, has earned high ratings for safety and financial management. But once you choose a high quality annuity, you'll be harnessing the power of compounding in triplicate.

The Southeast Missourian does not recommend that readers buy or sell stocks featured in this column, which is provided for informational purposes only.