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Response to Comments on the 10% Compounding Myth

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Yesterday, Ramit from I Will Teach You To Be Rich dropped by to leave a comment on my post, the 10% Compounding Myth. Like the writing on his site, it was a well-written piece.

Here's my response to his comments:

Thanks for the comment, Ramit. As an early user of PBwiki.com, I want to thank you for your part in creating the service (not sure if it's largely all you or not). I had a good chuckle when you mentioned Datek in your retirement guide. They merged with Ameritrade years ago it seems. I know, I still have a Datek (now Ameritrade) account.

There's definitely a reason to keep things simple, especially for your site. It's just that I can find very few examples of sites taking these factors into account in their calculations. It's always an example of how 8-12% compounds into a high number, never how 4-6% compounds into a respectable number.

And while taxes can be somewhat mitigated, even with 401k and Roth IRAs they are far from eliminated. While you will have control of how much you withdraw and thus the taxes, it's still likely to eat to be taxed at 20-25% (conservatively) for most people. That's giving up a quarter or a fifth of all those compounded gains. Clearly giving up 1/5 of the gains on those $300,000 charts is not something to be ignored.

The last point is the best, "what's the next-best alternative?" The alternative is to educate people about inflation and taxes up front. I understand you need to get readers' attentions. Show them a chart with the big money compounding at the beginning and they'll read the rest of the article. By the end of the article though, explain that the big chart doesn't take taxes and inflation into account and give them those views. That's what I'd do for Lazy Man and Money, but I think I take a more advanced view that comes from years of reading the basics. It seems you can get the basics anywhere, I want Lazy Man and Money to be more than that.

Ramit, if you were implying the "what's the next-best alternative?" to investing, there isn't one - you can't ignore the inflation and tax monsters. They are as certain as death and urrr, ummm, taxes. Your only hope is to try to outrun them and investing is one of the best known ways. Perhaps you could create a business as Ramit has with PBWiki.

Posted on January 5, 2007.

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4 Responses to “Response to Comments on the 10% Compounding Myth”

  1. And while taxes can be somewhat mitigated, even with 401k and Roth IRAs they are far from eliminated.

    I take issue with this statement. How are taxes not mitigated in a Roth IRA account?

  2. Lazy Man says:

    Well they are mitigated in both, but in the Roth IRA you just pay the taxes when the income is earned.

  3. Yosef Katz says:

    People that are less schooled reading about Roth IRA might think it is tax free. It is definitely not, there is no escape from taxes. The dollars that go into the Roth IRA are from taxable compensation or post tax dollars. Your reward for paying up front is that on the back end your earnings do not get taxed. This is actually potentially huge, so there is a limit as to how much you can put in your Roth IRA (sorry this sounds obvious but to some newer to the Roth concept it is not obvious).

    Tax Deferred is just that, this chart should be helpful to newer folk, specifically the line Tax Implications. Some are pre-tax dollars but no deduction (however employer may match or partial match) and some are post-tax with a filing deduction, etc…

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