If there's only one concept you need to know when saving for retirement, it's this: compound interest. With compounding, you make money on your money. You make interest on your interest.
With compounding, the returns start small, but get bigger over time. Much bigger. And it's the secret to growing your retirement dollars.
Here's how it works: if you have $100, and you invest it with a 10% return, at the end of a year you have $110. The next year, you are not just making interest on the $100, you are also collecting interest on the $10 in interest you earned. You now have $121. ($110 plus 10 percent return = $121)
Now let's apply this to a real-world retirement situation. Under most circumstances, the most you can invest in an individual retirement account is about $6,000 a year. Let's start with an initial $6,000 investment in, say, the S&P 500. Let's assume that you are expecting a total return (price appreciation plus dividends) of 6% (that is about the historic average), compounded annually.
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How much would you have after 10 years? You'd have $89,829. Here's how it would look:
A 10-year investment ($6,000 invested each year, 6% return, after 10 years)
Money invested: $60,000
Return on investment: $29,829
That is a nearly 50% return on your money in 10 years. Not bad!
Wait, it gets much better. Now let's look at what you would have after 20 years: $239,956. Your money doubles!
A 20-year investment ($6,000 invested each year, 6% return, after 20 years)
Money invested: $120,000
Return on investment: $119,956
And from here, the numbers get much bigger. After 30 years, you have $508,810. After 40 years, $990,286!
With compounding, it's not just the length of time that makes a big difference. The return is also critical, and just as with time, changing this variable by as little as one or two percent can result in huge differences in returns over long periods.
Let's go back to that 20 year return at 6%. Suppose we change the parameters and say we make only 4% a year, or up it to assume we make 8% a year.
A 20-year investment
($6,000 invested each year, after 20 years)
6% return: $239,956
8% return: $302,537
Look carefully: the difference between a 4% return and an 8% return with the same amount of money invested is more than $110,000 over 20 years.
Want to try this on your own? One of the simplest compounding calculators is run by the Securities and Exchange Commission.