Looking to plan for long-term financial security? Short of winning the lottery, inheriting a fortune from your Uncle Henry or hitting it out of the park on Shark Tank, the process is straightforward: spend less than you earn and save the rest. How you save can make a big difference, though. Your savings won’t grow anything but mold if stashed under your mattress. This is where investing and compounding comes in.
When you make regular contributions to an interest-bearing savings account or other investment account over time, you get to watch compounding at work. Compounding is when your investment earnings are reinvested – and can in turn start earning money for you. So basically, you get earnings on your earnings. It’s a snowball effect that gets more powerful the longer your money stays invested. And it’s particularly helpful in tax-deferred retirement accounts like 401(k) plans and 403(b) plans because your compounded earnings aren’t being reduced by taxes every year.
Three steps to compounding benefits.
To get the greatest benefits of compounding, you need to do three things:
- Start saving early. Compounding builds up steam over time. The earlier you start saving, the less you’ll need to put away every month to reach your ultimate savings goal if you’re getting positive returns on your investments.
- Save steadily and consistently. Take a disciplined approach and save a portion of every paycheck. In a 401(k) plan, your contributions are automatic so the discipline is built-in. Regularly adding money to your account helps increase the power of compounding.
- Have patience. Keep your savings invested for the long haul and avoid taking any withdrawals until you absolutely need the money. Compounding can begin to make a long term difference in your account value after years of consistent investing and positive returns.
Time equals opportunity.
The younger you start saving, the better. A 27-year old could be looking at a 40-year investment time horizon. That’s a lot of years for compounding to do its thing. If that 27-year old waited 10 years to start saving, the difference in potential account value growth could be significant. How significant? Let’s look at a hypothetical example.
Maria and Connor are 27-year old friends who got hired at the same company. Maria immediately started saving $300 a month in her 401(k). Connor figured he had plenty of time to save for his future so he waited 10 years and started saving $300 a month in his 401(k) at age 37. They both got an average annual investment return of 6% and reinvested all their earnings.
Maria and Connor changed jobs over the years but they never wavered in making those steady $300 a month 401(k) contributions.
When they met at a local restaurant to celebrate turning 67, they each brought their 401(k) account statements to brag about what good savers they were and how much money they had built up over the years. Maria proudly showed off her $597,458 balance. Connor couldn’t hide his disappointment. His account was worth $301,361.1 “I guess those 10 years I didn’t save really made a huge difference,” he lamented.
Both Maria and Connor saved steadily and had the patience to let their investments grow. But Maria’s earlier start gave her savings 10 more years to compound. Yes, she contributed $36,000 more than Connor during those 10 years, but that’s not the only thing that made the difference. With those extra contributions and time on her side, she ended up with over $250,000 in extra compounded account growth.
It’s never too late to compound your savings.
If your twenties are a distant memory and your retirement account balances aren’t where you’d like them to be, you still have options. Get aggressive with your retirement plan contributions and start today. You may need to save more each month, reach for higher investment returns or even postpone your retirement date to give your savings a few more years of growth potential. The important thing is to get started, wherever you are in life. You’ll never have more time than you do today.
Some people are lucky enough to hit a windfall of cash they can use to retire, but most of us aren’t. And while saving early is very helpful, it’s never too late to start. The power of compounding can be the fuel you need to help get to the retirement lifestyle you want.
1 Compounding growth example is for illustrative purposes only. This is not meant to predict future investment performance. Assumes a $1.00 starting balance, average annual returns of 6% compounded monthly with all earnings reinvested in a tax-deferred account. Taxes will be due at distribution. Your returns may be higher or lower.