Entrust Learning Center > 3. Investment Options > The Rule of 72What the Heck Is It!

The Rule of 72What the Heck Is It!

How do we make our financial decisions? Why do we invest the way we do and what is the benefit?

By: Dave Owens

IRA and 401(k) Insights

I think the current economy has put a cold dose of reality in every type of investor. Many of us now realize that when our parents were harping on hard work and telling us what the world used to be like, they were not kidding. Oh my gosh, did I say my parents were right?

Building wealth is a long-term process, and it is a ton of work. I think technology has helped us lose sight of how long it actually takes to build wealth. The Internet gives us instant access to so much information. We can invest in stocks and watch them all day long, or have an email sent to us every hour telling us how the market is doing. Today, I repositioned my portfolio only to look at it at lunch and find out it was down already. Why did I look?

This is where an old math formula called the Rule of 72 could never be more important and should be one of the first things that you learn when starting to invest. The Rule of 72 is used to project how fast you can double your money based on a certain rate of return. The formula is very easy, and it is very useful to understand how powerful compound interest really is.

If you divide 72 by the projected rate of return, you find out how long it takes to double your money. Let's go through a simple example. Assume I want to buy a rental house. I determine that with rental cash flow and market appreciation, I will get a 6% rate of return. I divide 72 by 6, and it tells me it will take 12 years to double my original investment (72 /6 = 12).

Now let's assume that you are in the highest tax bracket and Uncle Sam is going to tax one-third of your annual gain. So after you pay your taxes, your return is only 4% annually. Now let us apply the Rule of 72: 72 divided by the 4% return equals 18 years. Taxes or unexpected costs can quickly derail project profits or wealth.

That is why it is important to understand investing and all the options available. Some great tax strategies are available that a lot of people can take advantage of. Two popular strategies to help defer or eliminate taxes are 1031 exchanges and self-directed IRAs. By taking advantage of these strategies, your returns can be maximized by reducing taxes and helping you increase your returns sooner. Self-directed IRAs are also allows investors to use retirement funds to buy real estate and other alternative assets. The benefit is that no gains inside the IRA account are taxable until withdrawn. This can lead to a tremendous amount of wealth being accumulated in the retirement account.

The other option for real estate investors is a 1031 exchange, which allows you to sell your investment real estate (please note that this is non-IRA property) and pay no federal or state capital gain taxes on the transaction as long as you buy a new piece of investment real estate within the guidelines. Both strategies can benefit savvy investors. As always, consult your tax advisor for specific details regarding your situation and if you qualify.

The funny thing about the Rule of 72 is that the number we need to actually double our money is not 72, but 69.3. The Rule of 72 is an estimate. I think they thought no one would believe the Rule of 69.3, so somewhere along the line it was rounded up because it’s much easier to divide into 72.

If you want to know how long it will take you to triple your money, use the Rule of 110. For example, 110 divided by an 11% rate of return would mean it would take 10 years to triple your money.

These formulas do not require you to be a math wizard. You can quickly use them to understand the basics or variables of wealth building, and the time taken to calculate will them you as you grow your dreams.

Dave Owens, CPA, CES, is the managing member of Entrust Freedom, LLC, and has been a practicing tax accountant for over 20 years. Feel free to contact Dave with your questions at owens@entrustfreedom.com or 239-333-1031.

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