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Head+scratcherI just had a very interesting meeting with a young, 30-something client-prospect.  This man, husband, and father – was laser focused on making good financial decisions for himself and his family, and was saving money at a rate that will put him 15 years ahead of his peers.

It was really great to see commitment and discipline in action.

He came in however; to tell me that he was going to ‘stay the course’ he was on.  For him, that meant loading up on his SEP tax-qualified plan – having his wife load up on her 401k plan at work, and funding 529 college plans for his two kids.

His ‘advisor’ had convinced him that the compounding benefit of tax deferral would put him way ahead of any strategy that involved saving after-tax dollars (which was my recommendation).

He was buying the logic of tax deferral being better – hook, line, and sinker.

So I asked him to participate in a little exercise with me.  We know the “Rule of 72” tells us how long it will take to double a sum of money by dividing an interest rate into the figure – 72.  Therefore, at 7.2% annual growth, money will double in 10 years (72/7.2% = 10 years).

So he correctly concluded that $1,000 would double to $2,000 in 10 years if it grew at 7.2%.  Let’s assume that the $1,000 was pre-tax money going into his SEP, his wife’s 401k, or the kids’ 529 plans).

I then asked what would happen if he invested the after-tax equivalent ($700 – assuming a tax rate of 30%) for the same 10-year period.  Again, he correctly predicted would grow to $1,400 in 10 years.

“See,” he said – “$2,000 is more than $1,400 – proving the value of tax deferral.”

“Not so fast Grasshopper,” I replied.   The $2,000 is in a tax-qualified plan and is therefore 100% taxable.  “What’s left,” I asked, “if we tax the $2,000 at the same 30% tax rate?”  The answer of course is $1,400 – the exact same amount – to the penny – that the $700 after-tax figure would have grown to.

“There is no mathematical advantage to tax-deferral,” I declared.

He squinted and tilted his head to the side a bit.  Then his eyes brightened and he came firing back, “but the $700 account has grown to $1,400 – there is still tax due on the growth!”  Spoken like a true “Wall-Streeter” and exactly why his professional “advisor” had been so adamant that tax-deferred growth was better than investing after-tax dollars.

Except that the advisor lives in a world where all growth is taxed.  I live in a world where no growth is taxed.  In my world, the $1,400 ending balance would bear no tax liability whatsoever – in which case my original statement – “there is no mathematical advantage to tax-deferral” – is 100% true and accurate.

Thankfully, this really smart, committed young man had the financial curiosity to listen and learn – and he has now set his family up with a much better plan.  You can too – but only if you stop listening to the wrong people, and start listening to the right people.