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Power of Compound Interest

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In the following, we discuss compound interest and why it’s such a powerful tool for saving. It’s even stronger in a retirement account, because there are generally no taxes due annually. The combination of compound interest and tax deferral makes the IRA and 401(k) the best way to save. Of course, you have to follow the IRA Financial adage: start early, be consistent and trust the process.

Key Points
  • Compound interest can help grow your retirement savings
  • Starting early is key
  • Albert Einstein once declared compound interest to be “the most powerful force in the universe.”

Saving For Retirement

There’s nothing more important for your retirement than planning it early and contributing regularly – and compound interest can help. Putting money aside with each paycheck means you’re building a nest egg, and compound interest means it’s growing quickly.

Compounding, also known as compounding interest, is defined as “the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.” Compound interest is when you earn interest on your initial amount, and also on the interest that you earn. It adds up quickly and can help you save for retirement or any long term goal you may have. This means that it can be more important to save early and regularly then to just make large deposits. Below are some examples, which can help you see the massive power of compound interest.

Examples

Let’s say you have $5,000 in an investment and it grows 10% annually. After the first year, the investment will be worth $5,500. In year two, the 10% growth is based on the entire $5,500 amount. Instead of earning on just the original principle, your earnings are based on the principle plus the interest accrued during the first year. The growth for year two would be $550. The investment is now worth $6,050.

Or, let’s say you invest $100 per month for 10 years. You would wind up with about $18,000. But you’re only investing $12000. That difference? Compound interest, maximizing your retirement account because it’s monetizing the principle as well as the interest you’ve earned.

Benjamin Franklin

Benjamin Franklin once said, “A penny saved is a penny earned.” But compound interest means your pennies, and dollars, add up all the sooner. Instead of just earning money on the dollars you invest in your retirement, you’re earning money on the interest, too. Compounding builds on the length of time you’re investing and the regularity with which you invest. Franklin is also famously credited with saying, “Money makes money. And the money that money makes, makes money.” And that’s a definition of compounding that may make more sense. You invest your money and it earns interest. Then your money plus the interest earns even more.

Franklin also considered compounding interest as the “eighth wonder of the world.” Investing guru, Warren Buffett, also says the same thing. So, don’t just take it from us, heed the advice of two of the smartest men who have ever lived.

Banking

Banks or financial institutions that credit compound interest will use a compounding period such as annual, monthly, or daily. It’s important to know what length of time your bank will use. This is just one of the questions you may ask as you look for a site to bank your investment.

Traditional plans (both IRAs and 401(k)s alike) generally get an upfront tax break, since they are funded with pretax money.  What this means is that retirement plan contributions are taken out before your salary is taxed. Taxes aren’t due until you withdraw the money during retirement.    

On the other hand, Roth contributions are made with after-tax dollars. Unlike traditional plans, there is no immediate tax benefit.  However, all qualified distributions during retirement are tax-free. This means that it will take greater initial funding to equal a traditional contribution amount, but your takeaway will be greater at the end since all withdrawals (including earnings) are tax-free. So, if you funded the Roth with $1,000 and it grew to $180,000, the entire amount is free and clear once you reach age 59 1/2 and the Roth has been opened for at least five years. The power of compounding makes the Roth an attractive way to save for retirement.

Conclusion

The power of compound interest matters in investing. The difference it makes in savings is enormous, given enough time to do its job. Frequency of regular contributions and length of time making those deposits really influences the outcome in retirement accounts. You definitely want to make your money work as hard for you, as you do for it.

Compound interest is just one of many reasons to invest with retirement funds, and self-directing your retirement is another one. If you would like more information, please give us a call at 800.472.0646.

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