It would make sense to listen to the person who discovered the theory of relativity, and who, in 1921, won the Nobel Prize for his discovery of the law of the photoelectric effect. This discovery led to the development of modern electronics, including radio and television. There are many reasons to thank Albert Einstein for his contributions. But what would this brilliant scientist and mathematician know about retirement? We can sum this up in one simple sentence uttered by the genius. Einstein once said,
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
The question is, which side of the interest equation are you on? Are you earning it, or paying it? Most consumers are paying interest, and in large amounts. But this article is about making money on your money, and we are going to use Einstein’s formula to do it.
A compounded return is when you earn interest on your principle, and interest on the interest. Example: You have $50 and it earns 10% or $5. Now you have $55. During the next cycle, it earns 10%, but the gain is now $5.50 because of compounding. You made 10% on the initial investment of $50 and 10% on the interest it earned. This is the difference between simple and compound interest. If our scenario focused on simple interest, you would only gain interest on the initial amount invested, and not on any future gains. If you borrow money, be sure you are paying simple interest on the debt. If you are saving for retirement, compound interest should be your goal.
Hopefully, you are putting back some money each month for retirement. The frequently asked question is, how much should a person save out of each paycheck? The answer depends on who is going to do the most work; you or your money. Burn this statement into your brain: It’s not how much you save, that determines your retirement affluence, but when you save that does.
For example. Let’s say a worker decides to put back $100 a month for retirement. He is twenty years old, and his plan is to retire at age 70. The average return will be eight percent per year.
As you can see, at the end of 50 years, he will have accumulated a respectable amount of cash: $798,460. Notice the total deposit amount of $60,000. This contribution came out of his paycheck month after month, year after year, for 50 years, or 600 months, in order for him to arrive at this number. Another way to put it is that it cost our young investor $60,000, to make $798,460. This is one example of how compound interest can work for you. However, the investor is doing a large share of the work. It took him 50 years of constant contributions to arrive at this amount. Remember, it’s not how much you put back, but when you do it, that makes the difference.
Which side of the interest equation are you on?
Now let’s recalculate the same example above, but with a slight variance. Instead of paying in over a 50-year period, let’s assume our young worker elects to invest a larger amount into her retirement account, but only for the first year! If our protégé sacrificed for just one year, perhaps by working three jobs, shopping at Goodwill, and living on Ramen Noodles, so that she was able to put back $1,200 a month for twelve months, how would she make out? Keep in mind, this is a one-time event. After surviving such a grueling year of saving and sacrifice, she decides she will never put back another dime toward retirement. Where will she be 49 years later?
To begin with, her contribution total equaling $14,400, ($1,200 per month for 12 months), is less than 1/4th of the $60,000 invested by our first example. At the end of the same time period, she would end up with almost $100,000 more in her bank account, and at a fraction of the cost of the first investor. After that initial year, she could spend the next five decades spending her money anyway she wanted to, without any need to worry about her senior years.
The general belief is, the more time you have to let your money grow, the smaller your contribution can be toward retirement. No! No! No! The more time you have, the more money you should put back. This is how you make your money work for you 24/7. The larger the amount you invest when you’re younger, the sooner you can stop contributing altogether. This could also hasten your actual retirement date.
Before we leave this subject, let me say a word about triple compounding. What is triple compounding?
- Interest on your principle
- Interest on your interest
- Interest on deferred taxes
When you put money into a tax-deferred investment, such as a 401(k), or an IRA, you receive triple compounding. You don’t have to pay income tax on your gains until you pull the money out of the tax-deferred investment. The money that belongs to the IRS remains in the account, earning interest for you. Below is a chart showing what $100,000 can grow to, utilizing the triple compounding method, versus paying taxes in an individual account.
As you can see with triple compounding, you can almost double your investment return in a tax-deferred environment. If you are in the 39% tax bracket, and you pull out the entire lump sum at retirement, you would still be far ahead of the other figure. (Keep in mind that the tax table is based on a graduating system).
$684,848 – $171,212 (39% tax on a tier system) = $513,636
- Save as much as you can, as early as you can
- Deferring taxes on your gains as long as you can, is a great way to grow and sustain your investment dollars.
- If you want to keep ALL of your gains, put your contributions in a Roth IRA. There is no tax deduction for the initial contributions, but all of your gains are forever tax free.