Compound Interest: A Powerful Tool for Retirement Savings
Just do it!
Yes, that's Nike's slogan, but it could also be a rallying cry to motivate Americans to save for retirement. One of the most important steps you can take when it comes to saving for retirement is to just do it—nearly every advisor I’ve ever met has said to just start saving money no matter what your age or income. Once you do, you can let the power of compound interest work for you to grow your retirement account.
What is compound interest?
We all wish there was such a thing as free money. Well, compound interest can be seen as a way of earning free money to grow your retirement savings. (Of course, it’s not actually free since you’re being compensated with interest for the risk you’re taking of possibly losing your investment.)
Compound interest occurs when the interest earned on your investment is re-invested and earns interest. By earning interest on interest, your retirement savings account has the potential to snowball over time, and you may not need to put aside as much money to reach your retirement goals.
The chart below shows how compound interest can grow a savings account. If you place $1,000 in a retirement account with a 5% interest rate, by the end of Year 1, you will have earned $50 in interest and have total savings of $1,050. In Year 2, compounding kicks in and at the end of the year, you'll earn 5% interest on $1,050—resulting in an account balance of $1,102.50. At the end of 6 years, compounding will have earned you more than $340.
How can you calculate compound interest?
There are multiple online compound interest calculators to help you see how your savings with grow. The calculators often ask you to enter your initial investment amount, how many years you plan to save, and your expected annual interest rate.
For instance, the Investor.gov compound interest calculator says that at the end of 20 years, that $1,000 account with a 5% interest rate will grow into $2,653.30 — showing that compounding more than doubles your initial retirement savings.
How tax-advantaged IRAs boost the power of compound interest
At PENSCO, where we custody alternative assets in more than 51,000 self-directed retirement accounts, we have seen small IRA accounts grow into considerable nest eggs by combining the power of compounding with tax-advantages.
Holdings in a traditional IRA can compound year after year on a tax-deferred basis. If savings are held in a Roth IRA, account growth may accumulate tax free.
The chart below captures the growth trajectory of $100,000 invested in a tax-deferred account where the account holder makes annual IRA contributions of $5,500 compared to investing in a taxable account.
As the illustration shows, an IRA, supplemented with annual contributions, can be a very effective tool to save for retirement. As a tax deferred account, it reaps the benefits of greater compounded interest and returns because they are not being eroded by taxes. If you contributed $5,500 a year and made an 8% return, you would have nearly twice as much money at the end of 20 years in a tax deferred account than you would have in a taxable account.
Put compound interest to work: Start saving for retirement
There are many ways to start saving for retirement. Here are a few:
- Put aside money in a qualified plan (such as a 401(k)). You may be able to make income deferral contributions which your employer may match. I recommend you speak with your employer.
- If you are self-employed, you may be able to set up a retirement plan (e.g. Solo(k), SEP IRA, or SIMPLE IRA) for you and your employees.
- Open a Traditional or Roth IRA if you're eligible. A Traditional IRA is pre-tax, meaning you typically don’t pay taxes until you begin taking distributions on the cash or assets in the account. With a Roth IRA you make contributions to the account with after-tax dollars, but the earnings in the account may grow tax free. The 2018 IRA contribution limit is $5,500 with a catch-up contribution of $1,000 for individuals who are 50 and over.
If you're not sure which retirement savings plan will work best for you, we recommend speaking with a tax advisor and/or financial advisor. At PENSCO, we make it possible to grow your retirement savings by investing in real estate, private equity and notes through a self-directed IRA. If you are interested in learning more about how IRAs work and alternative investments, download our free IRA Investors Guide.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.