Compound interest is interest paid on interest.
At 5% interest compounded annually, you will have $105 after the first year. If you keep this investment for another year, you will be paid interest on your original $100 and on the $5 you made in interest the first year.
The longer you invest your money, the higher your interest payments will grow, not only on your original amount but on the additional interest you earn each year. This is what makes compounding interest so powerful.
The longer an investment is allowed to compound interest, the higher your returns will be.
Avoid the tax man
It will not do you a whole lot of good to compound the interest on your investments only to watch it get taken by the IRS. Fortunately, there are a few ways to compound your interest and avoid paying more tax than necessary.
Unless you invest in a tax-sheltered account, you will have to pay taxes on any investment growth at your regular income tax rate. Interest rates paid on bank accounts, bonds, and dividends (shared profits) are all generally taxable. If you are in a moderate tax bracket, this could mean around 30–35% in both state and federal taxes. So your 10% rate of return could end up being closer to 6% after taxes.
The answer can be found in tax-sheltered accounts. A tax-sheltered account lets interest grow within your account without being taxed until it is withdrawn.
This puts the power of compounding back into your hands, because your investment will continue to grow faster without taxes cutting into your growing interest.
What kinds of tax-sheltered investments can you use to protect your compounded interest?
Tax-deferred retirement plans such as individual retirement accounts (IRAs)
Municipal bond funds with reinvested dividends
Millions of investors have chosen these investments to enable as much of their wealth as possible to keep growing.
Dive deeper: Taxes on investments: Everything you need to know
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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