When people are young, saving for retirement is often the last thing on their minds. But starting young and saving every month can translate into a huge difference in your net worth at retirement - all through the power of compounding.
Compounding Interest - a Simple Concept
Compounding allows you to earn profit on your profit, or interest on your interest. Over an extended period of time, you can earn far more than you thought possible, particularly if the annual rate of return is eight percent or more. Even better, you can minimize taxes along the way.
To illustrate the power of compounding, take a dollar bill and invest it at a 10 percent rate of return. Every year, you earn 10 cents and at the end of the ten years you've doubled your investment to $2 - and that's without any compounding.
With compounding, in the second year, the 10 percent rate of return is added to your $1.10, and so on every year until at the end of those 10 years you wind up with $2.59. Compounding has increased the value of your investment by about 30 percent. Start multiplying that with larger amounts over even longer periods of times and you can see why it's important to start saving early.
There are four critical factors that affect how much you can accumulate before you retire:
- When you start saving (the earlier, the better).
- How much you save (the more, the better).
- The rate of return (the higher, the better).
- How much you pay in taxes (less is obviously better).
Focusing on the first factor, let's say you contribute $3,000 a year to a tax-deferred qualified retirement plan account. Depending on when you start saving and assuming an eight percent annual return, here's what you'll have at age 60:
Double all those totals if you're married and your spouse follows the same plan.
To further understand the significance of starting early, let's take a look at what a difference just five years can make.
Comparing the $516,950 you accumulate from age 25 to the $449,850 you get by delaying until you are 30, you can see that the difference is a whopping $177,100. Yet only $15,000 of that difference comes from additional contributions ($3,000 a year times five years equals $15,000). The remaining $162,100 is generated mostly by the power of compounding. That is, the interest on your interest.
Now, take a look at what happens when you contribute a total of $140,000 to a tax deferred retirement account earning eight percent a year, where the only difference is the age when you start saving:
The Best Strategy:
Get an early start. How soon you begin saving is just as significant, if not more so, than how much you put aside. Invest early and often.