The Rule of 72 - What is it?

By: Dave Owens

How do we make our financial decisions? Why do we invest the way we do and what is the benefit? 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 could never be more important. It is called the Rule of 72 and it should be one of the first things you learn when starting to invest. The Rule of 72 is a math formula 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 we divide 72 by our projected rate of return, we find out how long it will take us to double our money.

Let's go through a simple example. Assume I want to buy a rental house and I determine that with rental cash flow and market appreciation, I will get a 6% rate of return. I divided 72 by 6, and it tells me it will take 12 years to double my original investment (72 /6 = 12).

Now let's assume you are in the highest tax bracket and Uncle Sam is going to tax 1/3 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 4% return and the answer is 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. There are some great tax strategies available and they can be a great opportunity for everyone. Some of the most popular strategies that 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 the investor increase their returns sooner. Self-Directed IRAs are a great opportunity for investors to use retirement funds to by real estate and other alternative assets. The benefit is that no gains inside the IRA account are taxable until withdrawn. This can lead to tremendous amount of wealth being accumulated in the retirement account. The other option for real estate investors is a 1031 exchange. 1031 allows you to sell your investment real estate (please note 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 be a huge benefit to savvy investors. Please 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 actually an estimate, and I think they thought no one would believe The Rule of 69.3, so somewhere along the line it was rounded up because it is so much easier to divide into 72.

If you want to know how long it will take you to triple your money, it is actually 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.

While none of us want to be math wizards, it is important to understand the basics or variables of wealth building. In the long run it is will be well worth as grow your dreams.

Dave Owens, CPA, CES, is the CFO of Entrust IRA Administration, Inc and has been a practicing tax accountant for over 20 years. If you have any questions about this article and would like more information please feel free to contact your local office at 312-235-0300.