When planning your retirement, it’s not uncommon to get so bogged down in the minutiae of the numbers and assumptions that it is easy to forget you have certain forces at work for you. Albert Einstein called compound interest “the most powerful force in the universe.” While compounding interest is not nearly as difficult to understand as quantum physics, its magic has far greater application to your everyday life and is the key to your financial future.
The Magic Behind Compounding
We are all told early on that making regular contributions to your retirement plan is essential for a secure retirement. Those preparing for retirement might invest their contributions in various assets such as mutual funds, exchange-traded funds, and money market funds, which generate returns in the form of dividends, capital gains, and interest. Making systematic contributions to your retirement account is critical because the more you contribute, the more principal there is to generate returns.
Those returns are reinvested into your account and start earning even more returns. The magic of compounding stems from the fact that your money not only earns interest or returns on your principal but also on the returns.
Using the SEC’s Compound Interest Calculator, let’s take a look at how compound interest works over time to grow your savings.
Say you have a $1,000 earning 5% annually (and compounded annually). At the end of the first year, you would have earned $50 (5% of $1,000), totaling $1,050. In the second year, however, you’re now earning interest on both the original $1,000 and the $50 of interest, for a total of $1,102.50. At this rate, your account will double to $2,000 in about 14.2 years. (If you want to know how many years it will take for your money to double, divide the number “72” by the interest rate).
Time Provides the Magic
Of course, there can be no magic without time. The time your money has to work for you is the key to the magic of compounding interest. The longer you have until retirement, the more powerful the impact of compounding becomes because your investments have more time to grow and compound. Consistent contributions combined with compounding returns can lead to substantial growth in your retirement savings over several decades.
Consider the following example of two people who invest the same amount of money for retirement at different periods in their lives:
Starting at age 25, David contributes $20,000 a year to his retirement plan. Then, at age 45, he stopped saving altogether.
Wendy waits until age 45 before contributing $20,000 to her retirement plan and continues to save until age 65.
Assuming they each earn 6% annually on their retirement savings, at age 65, David will have accumulated more than $2,500,000 while Wendy would have just less than $800,000. Yet, they both saved the same amount of money.
As you can see, the longer time horizon worked in David’s favor despite the fact he stopped making contributions at age 45. As for Wendy, missing out on 20 years’ worth of contributions cost her a tremendous amount of money.
Tax Advantages Boost Compounding
Because earnings inside a qualified retirement plan are tax-deferred, you keep more money working for you, enhancing the compounding effect by allowing your investments to grow more efficiently.1 You will eventually pay taxes when you take withdrawals from your account (except if it’s a Roth IRA), but the compounded growth of your capital can provide a cushion against them.
The Importance of Diversification
With the power of compounding working for you, generating steady returns on your investments is essential. A well-diversified portfolio can produce returns from capital gains, dividends, and interest, all of which can be reinvested and compounded. It also helps mitigate the inherent risks of investing in equities or bonds while maximizing returns. Because you can’t know which investments will outperform others at any given time, investing in various assets that perform differently in varying market conditions gives you more opportunity to capture returns while minimizing portfolio volatility.
Your retirement contributions and the returns you earn on them are the catalysts for accumulating a retirement fund. But it’s the magic of compounding that fuels their growth to an exponential level. Time is the critical element, so the earlier you start making contributions consistently, the more substantial the nest egg you’ll have for your retirement years.
Sources:
1Taxation of Retirement Income
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