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“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
-Albert Einstein
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You probably have come across time value of money in one your finance classes or at least have a basic understanding of the idea. Time value of money, as defined by Investopedia.com, is “the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.” Basically, money is worth more now than it is later. This idea would not exist however, if there was no concept of “interest”.
There are two types of interest – simple and compound. Simple interest is interest paid on a beginning principal balance only. If you are receiving monies, the interest earned in a given period is not added back to the principal and then applied the interest rate again and appears perfectly linear on a graph. Compound interest is interest paid on a beginning balance and any interest that has accumulated in given a period of time. On a graph compound interest appears with a geometric (or exponential) growth pattern.
The present value of a future sum is the core formula for the time value of money. All time value of money equations are based off this formula so it is extremely important to review. It is expressed as such:
PV = FV / (1 + i)^n
Where
PV = Present Value
FV = Future Value
i = interest rate
n = number of periods
The future value of a present sum is expressed as FV = PV * (1 + i) ^n. We won’t discuss perpetuities or annuities in this post nor will we execute any actual calculations with the TMV formulas.
So how can we use this time value of money concept for tax optimization and more importantly, individual wealth?
Retirement Planning: We have all seen the example where Johnny starts an IRA at age 35 while Susie starts one at 21 and the amazing difference of the account values when they both reach age 59 and a half. This is because Susie’s IRA endured 14 more years of compounding. The choice between a roth and a traditional IRA has important tax implications and time value of money has some influence in the decision. With a Roth IRA for example, the taxpayer can receive tax free distributions of earnings at age 59 and a half while with a traditional IRA, the taxpayer receives an above the line deduction on IRA contributions – given that AGI thresholds are not crossed – and is taxed on the distributions. If your income is expected to increase as you get older and your marginal tax rate is also expected to increase, then a Roth IRA makes more sense – naturally. Do the immediate tax savings of traditional IRA contributions outweigh Roth IRA tax free distributions?
Tax Planning: Accelerate deductions, postponing income recognition. This concept goes hand in hand with the time value of money concept – money today is worth more than money tomorrow. By accelerating deductions you essentially reduce your taxable income and end up with a bigger refund or smaller balance due. Some examples include prepaying your home mortgage interest in a given year, making an alimony payment in December as opposed to January, and writing off an asset using section 179 expensing or bonus depreciation as opposed to depreciating it over several years. The amount of tax savings probably doesn’t have enough compounding power for individuals to make a huge substantial presence but for well established businesses it most definitely does. Examples of postponing income are increasing your retirement plan contributions to a 401(k) plan, legally deferring compensation, and delaying the collection of any debts you are owed.
Investment Planning: Younger people can be more aggressive because they have more time to make up for their losses. A younger person’s portfolio can afford more risky securities such as stocks. As one gets older, the switch to dividend producing stocks and bonds usually happens because the “interest rate” is more stable.
With time value of money, the uncertainty of the interest variable is the most difficult to tame. Those who can predict its patterns the best, tend to make the most money.
Heya Finance Guy,
That’s a great example as well. Save early and save often!
Also, one of the best investments you can make is in your health. The amount of money you will save on medical bills will be astounding.
I used to have an example showing that a larger amount was accumulated at age 65 by saving $10K per year for retirement over ten years starting at age 25 and then stopping compared to starting at age 40 and saving the same amount per year for twenty years. I can’t remember the annual rate of return assumption for compounding, but I could probably figure it out with a financial calculator.