Tax Benefits and Asset Growth

Let me ask you — if you were trying to build a herd of cattle from one bull and one cow up to a hundred head, would you get there faster if the government took away two out of every ten calves that were born, or if it let you keep all the calves? Pretty dumb question, huh? In fact, if that were the law, probably people would have given up on ranching a long time ago, figuring that if the government likes cattle that much, it can raise 'em itself! But that's the same problem you'll have if you try to make money investing.

You see, if you lend me $1,000 for a year, at 10% interest per year, and you pay me back, the government says you've made $100. They call that “interest income,” and charge you taxes on it. Say they tax you $28 on your profit. Now you've got $1,068 to go back out there and lend to someone else. It would be nice if you could keep all the money and keep right on lending larger and larger amounts of money. If you do the math, it's obvious your money will accumulate much faster if you can keep it all.

When you put money into a 401K Plan, or a Self Employed Person IRA (a “SEP IRA”), or a Roth IRA, as long as you keep it in that special account, you can reinvest all the interest income that the money generates and it keeps growing. It keeps compounding. That's what people call the magic of compound interest.

There are other tax benefits of putting money into a 401K or SEP IRA — up to a certain limit, the government will pretend that any money you put into these retirement accounts wasn't really income! Yes, the IRS will actually ignore that money, and thus, your total tax liability for the year will be lower. How this usually works out is like this — your accountant will tell you: “Look, you can pay the IRS $7,000 this year, or your can put $5,000 in an IRA, and pay the government $4,000.” Obviously, if that's the deal, you should pay yourself the $5,000, because the government is basically going to give you $3,000 of that amount. Get it?

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