The Power of Compounding Returns — After Tax
Most people have heard of “compounding interest,” but few truly grasp just how powerful it can be when it comes to building wealth. The principle is simple: you earn returns on your original investment, and then you earn returns on those returns — over and over again. Over time, this snowball effect can turn modest contributions into significant wealth.
But here’s the catch — what really matters is your after-tax return, because tax can quietly erode the compounding effect.
How Compounding Works
Let’s imagine you invest $10,000 and earn 6% per year. In year one, you earn $600. If you reinvest that $600, your investment in year two earns 6% on $10,600 — that’s $636.
The next year, it’s $674. And so on. The growth accelerates because each year, your investment base gets bigger.
After 20 years at 6% (before tax), your $10,000 becomes about $32,000. But the outcome is different once we factor in tax.
Why After-Tax Returns Matter
Tax reduces the amount you can reinvest, which slows the compounding effect. For example:
| Investment Type | Pre-Tax Return | Tax Rate Applied | After-Tax Return | Value After 20 Years (on $10,000 invested) |
|---|---|---|---|---|
| Bank account (interest taxed at 34.5% incl. Medicare) | 3% | 34.5% | 1.965% | $14,660 |
| Fully-franked Australian shares* | 7% | ~19% (after franking) | 5.67% | $30,170 |
| Superannuation — deductible contribution (earnings taxed at 15% + upfront tax saving) | 6% | 15% earnings tax | 5.1% (earnings) + upfront 19.5% benefit** | $32,370 |
Assumes franking credits can be used to offset tax; actual rates will vary depending on personal circumstances.
**For someone on a 34.5% marginal tax rate (including Medicare levy), contributing $10,000 to super instead of investing after-tax means they only forgo $6,550 of take-home cash — so the compounding starts on a higher base.
Where Compounding Works Best
From a purely mathematical perspective, compounding is most powerful when:
Returns are higher (obvious, but worth stating)
Tax is lower on those returns
You reinvest rather than spend your earnings
Time is longer — compounding rewards patience
This is why long-term investments in tax-efficient structures (like superannuation or certain trusts) can potentially produce much stronger after-tax outcomes than the same investment in your personal name at a high marginal tax rate.
Key Takeaways
Focus on after-tax returns — not just the headline rate.
Give compounding time — the real magic happens in the later years.
Choose your investment structure wisely — tax rules differ between personal accounts, companies, trusts, and super funds.
Reinvest earnings — compounding only works if the returns stay invested.
Disclaimer: This information is general in nature and doesn’t take into account your personal circumstances. You should seek professional advice before making any financial decisions.
