The Power of Compounding 

Start understanding the power of compounding

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It’s never too soon to start saving for retirement – the earlier you contribute money to a retirement account, the better your results will be. Compounding is the reason that an earlier start is better. Compounding is the growth of earnings. For example:

  • $1,000 invested in January could grow by 3% between January and August to a total account balance of $1,030.

  • The investor now has $30 in earnings in addition to the initial $1,000 investment.  ($1,000 x 1.03 = $1,030)

  • Then the account balance could grow by 4% between September and December.

  • The August account balance of $1,030 would grow by 4% during the latter part of the year.  ($1,030 x 1.04 = $1,071.20)

  • When figuring September-to-December growth, we begin with the $1,030 figure that includes earnings – so we include the growth of earnings in our calculation.

Compounding Earlier is Better

Without examining the numbers, many people believe it's relatively easy to recuperate from a late start in saving for retirement. Investors theorize that a little larger annual investment will offset a later start. To understand the difference between an early start and a late start, review the graph below.

the_power_of_compounding-2


For a detailed breakdown of the graph above, check out these Compounding Tables. You can see that a person who begins saving a small amount annually at the age of 25 could contribute a total of $392,500 during the 40 years between age 25 and age 65. At an average annual growth rate of 7%, that $392,500 would grow to $1,434,082.58 at age 65. By contrast, a person who waits until age 40 could contribute a total of $505,000 during the 15 years between age 40 and age 65. At the same 7% average annual growth rate, that $505,000 would grow to $1,200,608.23 at age 65. The big-picture lesson from this simplified example: market growth being equal, someone who starts investing at age 40 would invest more in order to earn less than a person who started at age 25!! More years of compounding will generally make a huge difference.

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The above graphs illustrate an average 7% annual growth for these fictional investment accounts. Smart401k does not guarantee any rate of return on investment advice. Please note that the above example is for illustrative purposes only.