The Power of Compounding

 

Compounding Interest is the factor that can significantly build wealth for young adults.

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Most wealth builds gradually. Sometimes it grows without any significant financial sacrifice. You can cite one factor that promotes wealth building perhaps more than any other – the power of compounding.

If you are decades away from retirement, you have an excellent opportunity to put that potential on your side by saving and investing through a tax-deferred retirement account. The next three paragraphs will show you just how remarkable the compounding in one of these accounts can be. These are hypothetical examples, but the math is indeed compelling.

As Michael enters his thirties, he starts contributing to the retirement plan sponsored by his employer. He initially puts $500 into the plan and directs $500 a month into the plan going forward. He keeps doing this, month after month, and his invested assets benefit from a consistent 7% return. Michael retires at age 65. After 35 years, how much does his retirement plan account contain under these conditions? $210,000? No, those are just his total contributions across 35 years. With annual compound interest, at age 65 the account would contain $865,883. [1]

Twenty-five-year-old Megan works for the same employer, and she decides to start saving for retirement five years before her co-worker Michael. Like Michael, she retires at 65. Like Michael, Megan directs an initial $500 into her account and $500 per month going forward with the investments in the account returning 7% a year. The only difference is that she begins to save for the future five years earlier. At age 65, she is looking at $1,250,246. [1]

In the late stages of retirement saving, the effect of compounding grows. Twenty years after opening her retirement plan account at work, Megan sees a balance of $257,138. Just ten years later, the balance has ballooned to $591,839. A decade later, it has more than doubled again to $1.25 million. [1]

Three other factors are aiding the growth of Michael’s and Megan’s accounts. One, tax deferral; there was no yearly subtraction of assets. Two, a consistently good rate of return for the investments; there were no bad years, nor were there any spectacular ones. Three, they left the money alone; they refrained from taking loans or early withdrawals from their retirement plans.

These examples do disregard some realities. Retirement accounts come with administrative fees, and those annual fees (which in some cases can top 1%) can effectively eat into returns. As Money pointed out recently, the difference between a 1% annual fee and a 0.25% annual fee could mean $100,000 or more in lost compounding over 30 years. The annual return on an account may, of course, vary significantly from year to year; real-world investment performance is not so consistent. On a positive note, the examples also ignore the reality that many people increase their retirement contributions with age as their income rises. So, inflows into these accounts may grow and enhance compounding. [2]

The primary lesson, however, is clear. If you are a young investor with a chance to direct money into a tax-deferred retirement savings account–begin saving and investing for the future now. Time is truly on your side. If you wait ten or twenty years, you may have to contribute uncomfortably large amounts of money to your account each year to try and catch up to where you want to be in terms of saving – amounts your household finances may not permit.


Advisory services offered through Meridian Wealth Management LLC, a Registered Investment Advisor.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

This article links to information on Investopedia.com

Citations.

1 - bankrate.com/calculators/savings/compound-savings-calculator-tool.aspx [3/8/18]
2 - time.com/money/5137127/retire-richer-401k-mutual-fund-fees/ [2/15/18]

 
Niki D.