Saving for retirement is a little more complex than simply depositing money into a 401(k) or IRA plan. Starting to make contributions as early as possible and as much as possible maximizes the benefits of compound interest over time. To learn how to make it work in your favor, read below.
What Is Compound Interest?
Compound interest is the interest you earn from an original contribution plus interest you’ve made on an existing investment, meaning that your interest earns interest over time. The more time your money has to compound and grow, the better it will be for your retirement.
The key? Give your money as much time as possible to grow.
What Impacts Compound Interest?
There are several factors that impact compound interest:
Time: The earlier you start, the greater the payoff. The more time you have to allow your money to build on itself, the better results you’ll see. Of course, everyone has a different timeline and different budgetary restrictions, so work with a financial advisor if you need assistance determining a good timeline for your goals.Contributions: Many financial advisors recommend increasing your retirement contributions every year. As you earn bonuses or get raises, it’s important to factor in your new income for the future. The more money you have invested in an account, the more growth you should see over time as interest compounds.Investment Type: Ramsey Solutions recommends utilizing mutual funds to grow your investments with compound interest. As a fairly stable investment type with a historical average rate of return between 10-12%, mutual funds can help participants grow funds steadily over time without major risk.Tax Rates: Utilizing tax-deferred accounts, such as a traditional IRA, Roth IRA, 401(k), or SEP-IRAs can impact compound interest. According to The Balance, it’s better to pay taxes on funds at the end of a compounding period rather than at the end of each year because it allows your funds to grow for a longer period of time before paying taxes on the growth. Please note that traditional retirement accounts that are not tax-deferred will require you to pay on the original growth and compound growth when you withdrawal the funds in retirement.
The Power of Opportunity Cost
One of the overarching ideas when considering compound interest is the opportunity cost of money. Think of every dollar you save today as a seed. You could spend it now—or plant it and let it grow into something much bigger.
An example used by The Balance is: Having $100 dollars today is good because you can invest it and watch it generate income and compound interest through retirement, meaning that when you retire, the $100 you contributed today will be a much larger amount.
This is why time and money are considered the main components for wealth accumulation. The more time you have to invest, the longer your funds have the chance to ebb and flow, and eventually, grow.
