As often attributed to Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
Compounding occurs when an investment’s earnings are reinvested to generate their own earnings. Compounding is an important wealth management tool, as compound growth can enable greater wealth generation than linear growth (see Figure 1).
1. For illustrative purpose only. Assumption: Compound Growth assumes an $1,000,000 initial investment accumulating at a growth rate of 8% with reinvestment of dividends and earnings. Linear Growth assumes an $1,000,000 initial investment accumulates at a growth rate of 8% with no reinvestment of dividends or earnings. This illustration compares compound growth versus linear growth. The assumed rate of return is not guaranteed and involves risk. Investment losses could affect the growth of the investment. Tax rates on capital gains and dividends will impact the investment's return. No federal or state income tax rates are considered, and including these taxes would impact the overall performance of the investment. No early withdrawals or non-qualified expenses are assumed. Investors should consider their investment horizon and tax bracket, as this illustration may not reflect these factors.
Asset location is a tax-minimization strategy that seeks to maximize investors' after-tax returns by considering investments' tax treatments when placing them in either tax-advantaged or taxable accounts. By locating high-yielding, tax-inefficient investments in tax-advantaged accounts, investors can limit tax drag and further unlock the power of tax-deferred compounding.
Tax-advantaged accounts can offer a range of benefits, including deductible contributions, tax-deferred or tax-exempt earnings, and, in some cases, tax-free withdrawals. Investors use tax-advantaged accounts for a variety of financial planning purposes, including but not limited to retirement, wealth & estate planning, education, healthcare, simplified tax reporting, and greater access to sophisticated investment strategies.
Tax deferral allows an investment’s earnings to accumulate without incurring taxable gains until withdrawal, providing investors greater control over where, when, and how much income is realized. Tax-deferral can result in greater portfolio growth as earnings that would’ve been paid to taxable jurisdictions remain invested in the portfolio.
Tax-advantaged accounts help limit tax drag, which increases the net dollar invested and can compound to generate additional gains and interest. This combined concept of tax-deferred compounding can help snowball portfolio growth. Tax-deferred compounding can be particularly beneficial for investors with long investment horizons who invest in asset classes that generate high ordinary income.
The illustrative example below compares a $1mm initial investment compounding at an 8% growth rate over time in a taxable account vs. tax-advantaged account (see Figure 2). At Year 40, the illustrative tax-advantaged account demonstrates an 108% after-tax outperformance compared to the same investments made in a taxable portfolio.
2. For illustrative purpose only. Assumption: $1mm initial investment accumulating at a growth rate of 8%, short-term capital gain tax rate of 37%, which reflects the highest federal income tax bracket in the U.S, and net investment income tax of 3.8%. This illustration compares the compounding effects of a $1,000,000 investment in an income-generating taxable product held in a taxable account versus a tax-advantaged account, assumes all growth is 100% ordinary income and 100% withdrawal during the ending year. The assumed rate of return is not guaranteed and involves risk. Investment losses could affect the relative advantage of taxable versus tax-advantaged investments. Tax rates on capital gains and dividends will impact the investment's return, and while this illustration only considers short-term gains, long-term capital gains may be taxed at different rates and could impact the investment's return. Withdrawals from a tax-advantaged investment will be subject to ordinary income tax rates. No state income tax rates are considered, and including these taxes would impact the overall performance of the investment. No early withdrawals or non-qualified expenses are assumed. Investors should consider their investment horizon and tax bracket, as this illustration may not reflect these factors. Note: The after-tax comparison reflects the impact of taxes during the payout period.
In summary, tax-advantaged accounts demonstrate the potential for higher after-tax values compared to taxable accounts, by limiting tax drag and unlocking tax-deferred compounding. To apply the power of tax-deferred compounding, please see the Appendix section for common types of tax-advantaged accounts that allow contributions to be directed into investment offerings
Compounding occurs when an investment’s earnings are reinvested to generate their own earnings.
Tax-advantaged accounts have the potential for higher after-tax values compared to taxable accounts, by limiting tax drag and compounding tax-deferred.
Investors can apply the power of tax-deferred compounding by locating tax-inefficient investments in tax-advantaged accounts.
Tax-advantaged accounts can be used for a variety of financial planning purposes, including but not limited to retirement, wealth & estate planning, education, healthcare, simplified tax reporting, and greater access to sophisticated investment strategies.
Individual Retirement Arrangements (“IRAs”) allow individuals to make tax-deferred investments that can help provide financial security at retirement.³
Traditional IRA: A tax-advantaged personal savings plan in which contributions may be fully or partially tax-deductible, depending on filing status and income, whereas earnings and gains are not taxed until withdrawal from the IRA.³
Roth IRA: A tax-advantaged personal savings plan in which contributions are not tax deductible, but qualified distributions may be tax free.³
Qualified Retirement Plans are employer-sponsored retirement plans that meet Internal Revenue Code (IRC) and the Employee Retirement Income Security Act (ERISA) requirements, providing tax advantages to both employers and employees.⁴
401(k): A retirement plan that allows employees to contribute a portion of their wages to individual accounts. Employers can contribute to employees’ accounts.⁵
403(b): A retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations. This plan is also known as a tax-sheltered annuity or TSA plan.⁵
457 Plans: A retirement savings plan that allows employees of certain state or local governments and tax-exempt organization under IRC 501(c) to make salary reduction contributions that grow tax-deferred. Employers can contribute to employees’ accounts.⁵
Simplified Employee Pension IRA (“SEP-IRA”): A retirement savings plan that allows employers to set up and contribute to employees’ traditional IRAs. SEP plans are available to businesses of any size, including self-employed.³
Savings Incentive Match Plan for Employees IRA (“SIMPLE IRA”): A retirement savings plan that allows both employees and employers to contribute to employees’ traditional IRAs. SIMPLE IRA plans are ideally suited for small employers who do not currently sponsor a retirement plan.³
Annuities are contracts in which individuals make lump sum or periodic premium payments to insurance companies. In exchange, investments grow tax-deferred and insurance companies ensure predictable periodic payments to annuitants, either immediately or at a future time, often as retirement income.⁶
Fixed Annuity: A contract in which the insurance company guarantees the annuitant both a minimum interest rate and fixed number of periodic payments.⁷
Variable Annuity: A contract in which the insurance company allows the annuitant to direct annuity payments into investments. An annuitant will receive a variable payout, depending on the invested amounts, rates of the returns on investments, and expenses.⁷
Indexed Annuity: A contract in which the insurance company credits the annuitant with returns based upon a designated market index, combining features of securities and insurance products. Policy owners can allocate cash values to more than one index.⁷
Private Placement Variable Annuity (“PPVA”): A type of variable annuity that is institutionally priced and designed for Accredited Investors and Qualified Purchasers. PPVAs include a cash value component that can be invested in private market offerings and accumulate tax-deferred. Invested premiums are held in the Insurance Carrier’s Separate Account, providing additional creditor protection.
Permanent Life insurance is a contract in which an individual or entity makes premium payments to an insurance company for the policyholder’s full lifetime. In exchange, the insurance company pays the named beneficiaries on the insurance policy a federal income tax-free death benefit, providing financial security and support upon the policyholder’s death.⁸,⁹
Whole Life Insurance: A type of permanent life insurance that provides lifetime coverage and has a cash value savings component that accrues at a fixed rate. It has fixed monthly premiums and death benefit.⁸,⁹
Universal Life Insurance: A type of permanent life insurance that provides lifetime coverage and has a cash value savings component that can accumulate interest or cover the cost of insurance. It has flexible premiums and death benefit. ⁸,¹⁰
Guaranteed Universal Life Insurance (“GUL”): A variation of universal life insurance that provides lifetime coverage and minimal cash value. It has fixed premiums and a guaranteed minimum death benefit.
Indexed Universal Life Insurance (“IUL”): A variation of universal life insurance that provides lifetime coverage and has a cash value savings component that earns interest by tracking the performance of a designated market index. It has flexible premiums and death benefit.⁸,⁹
Variable Universal Life (“VUL”) Insurance: A variation of universal life insurance that provides lifetime coverage and has a cash value savings component that can be directed into investment offerings, combining features of universal life insurance and variable life insurance. It has flexible premiums and death benefit.⁸,⁹
Private Placement Life Insurance (PPLI): A type of permanent life insurance that is institutionally priced and designed for Accredited Investors and Qualified Purchasers. PPLIs include a cash value component that can invest in private market offerings, accumulate tax-deferred, and correspond to an insured net amount at risk that provides for a federal income tax-free death benefit. Invested premiums are held in the Insurance Carrier’s Separate Account, providing additional creditor protection.
529 plans are tax-advantaged savings accounts designed to help save for future eligible education expenses, such as tuition, books, and certain living costs. There are two main types of 529 plans : educational savings plans, in which contributed dollars can be invested into a preset selection of investment options, and prepaid tuition plans, in which account owners can lock in current tuition rates for future attendance at select colleges and universities. These accounts are funded with post-tax contributions, so earnings are not subject to federal income tax and generally not subject to state income tax when used for qualified education expenses. Furthermore, the Secure 2.0 Act allows 529 plan owners to rollover unused dollars, tax- and penalty-free, into Roth IRAs, subject to certain limitations and specific requirements. ¹¹,¹²
Health Savings Accounts (HSAs) are tax-advantaged savings accounts designed to help save for future qualified medical expenses. Some HSA administrators allow contributions to be directed into investment offerings Annual contributions are tax-deductible, earnings grow tax-deferred, and distributions are tax-exempt when used for eligible expenses. At age 65, HSA dollars may be withdrawn penalty-free for non-qualified medical expenses but are subject to ordinary income tax treatment. ¹³,¹⁴
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Endnotes
Important information
Unless otherwise indicated, the Report Date referenced herein is December 31, 2024.
Past performance is not a guarantee of future results.
The material presented is proprietary information regarding Blue Owl Capital Inc. (“Blue Owl”), its affiliates and investment program, funds sponsored by Blue Owl, including the Blue Owl Credit, GP Strategic Capital Funds and the Real Asset Funds (collectively the “Blue Owl Funds”) as well as investment held by the Blue Owl Funds.
The views expressed and, except as otherwise indicated, the information provided are as of the report date and are subject to change, update, revision, verification, and amendment, materially or otherwise, without notice, as market or other conditions change. Since these conditions can change frequently, there can be no assurance that the trends described herein will continue or that any forecasts are accurate. In addition, certain of the statements contained in this presentation may be statements of future expectations and other forward-looking statements that are based on the current views and assumptions of Blue Owl and involve known and unknown risks and uncertainties (including those discussed below) that could cause actual results, performance, or events to differ materially from those expressed or implied in such statements. These statements may be forward-looking by reason of context or identified by words such as “may, will, should, expects, plans, intends, anticipates, believes, estimates, predicts, potential or continue” and other similar expressions. Neither Blue Owl, its affiliates, nor any of Blue Owl’s or its affiliates' respective advisers, members, directors, officers, partners, agents, representatives or employees or any other person (collectively the “Blue Owl Entities”) is under any obligation to update or keep current the information contained in this document.
This presentation contains information from third party sources which Blue Owl has not verified. No representation or warranty, express or implied, is given by or on behalf of the Blue Owl Entities as to the accuracy, fairness, correctness or completeness of the information or opinions contained in this presentation and no liability whatsoever (in negligence or otherwise) is accepted by the Blue Owl Entities for any loss howsoever arising, directly or indirectly, from any use of this presentation or its contents, or otherwise arising in connection therewith.
All investments are subject to risk, including the loss of the principal amount invested. These risks may include limited operating history, uncertain distributions, inconsistent valuation of the portfolio, changing interest rates, leveraging of assets, reliance on the investment advisor, potential conflicts of interest, payment of substantial fees to the investment advisor and the dealer manager, potential illiquidity, and liquidation at more or less than the original amount invested. Diversification will not guarantee profitability or protection against loss. Performance may be volatile, and the NAV may fluctuate.
Performance information
Where performance returns have been included in this presentation, Blue Owl has included herein important information relating to the calculation of these returns as well as other pertinent performance related definitions.
This presentation is for informational purposes only and is not an offer or a solicitation to sell or subscribe for any fund and does not constitute investment, legal, regulatory, business, tax, financial, accounting, or other advice or a recommendation regarding any securities of Blue Owl, of any fund or vehicle managed by Blue Owl, or of any other issuer of securities. Only a definitive offering document can make such an offer.