Compound Interest: A Resource for Young and Older Investors
The Rule of 72 can be used to estimate how long it takes to double a sum of money. Simply divide 72 by the interest rate earned on an investment. To fully appreciate the power of compound interest, consider how many doubling periods are available if someone starts saving a lump sum in their twenties or earlier. At an average annual return of 8% over time, a sum of money would double every nine years, with seven 9-year doubling periods between ages 22 and 85.
The growth of relatively small regular deposits, beginning at an early age, is also impressive. As shown in the NEFE High School Financial Planning Program® Student Guide, someone who saves $1,000 a year for ten years from ages 16 to 25 ($10,000 total) would accumulate $131,050 by age 50. Someone else who saves $1,000 a year from ages 26 to 50 ($25,000 total) would have only $84,701, a difference of $46,349. This illustration assumes a 9% average return.
Saving early in a Roth IRA (Individual Retirement Account) fully maximizes the awesome power of compound interest. Contributions can be made up to the lesser of $3,000 (through 2004) or 100% of earned income. The beauty of starting a Roth IRA in one's teens is that, in most cases, little or no income tax is initially owed on the amount contributed because incomes are generally low. On the back end, it is possible to amass over $1 million tax-free at retirement. Of course, young people must earn an amount equal to that placed into a Roth IRA. Gifts from grandparents don't count. The actual dollars that are saved can come from another source (e.g., parents) as long as there are equal documented earnings by the account owner (child).
For every decade that a person delays savings, the required investment needed to reach a specific goal approximately triples. The sooner one starts investing, the higher the amount saved, and the greater the average annual return, the easier it is to accumulate a seven-figure portfolio at retirement. Investment volatility, such as that being experienced today, is also reduced as an investor's time horizon lengthens.
Time is an even more valuable resource to middle-aged people who've saved little for retirement and are playing catch-up. The good news is that it's not too late to benefit from the magic of compound interest. If you're 50 years old and live to age 90, you have 40 years to grow your money. If savings accumulated through age 50 forward earns an 8% average annual return, it will double every nine years at ages 59, 68, and 77, and possibly even ages 86 and 95, according to The Rule of 72.
In addition, at least through 2010, workers age 50 and over can contribute additional catch-up amounts to both IRAs and tax-deferred employer retirement savings plans. By 2006, 50+ year olds can save $5,000 a year in IRAs and $20,000 in tax-deferred employer retirement plans. According to research by the T.Rowe Price investment firm, 50-year olds making the maximum contribution allowed each year to both an IRA and a tax-deferred plan, and earning an 8% return, could amass a portfolio of $500,000 by age 65. Accumulations are even more impressive when an employer matches worker contributions.
The problem with the above scenario is that it assumes savings as much as $26,000 a year when the 2001 tax law is fully phased in. This is simply unaffordable for many people. Even small increases in savings, however, can have an impact. Savings of $100 per month at a 6% return, will grow to $45,565 in 20 years and $97,924 in 30 years. Increase the amount slightly to $150 per month and you'll have $68,346 and $146,886, respectively.