Saving for retirement seems like a daunting task with an end goal far off in the future. We all wish we could flick a switch, work on retirement for a little bit, and be done. That simply isn’t the case. You have to be incredibly disciplined with your saving on a monthly basis for month after month, year after year, until you hit retirement age. You have to be wise to avoid jumping into hot stocks or sectors of the market and instead remain disciplined in your portfolio diversification. As difficult as saving for retirement can be, there is one part of retirement saving that is on your side: compound interest.

Contributions Alone Are Not Enough

If you and your spouse each opened a Roth IRA today, you could contribute a maximum of $5,500 to each Roth every year ($11,000 total). If you were diligent and hit the contribution limit every year for 30 years, you would set aside $165,000 in each Roth IRA ($330,000 total) for retirement. While that is a substantial amount of money, it certainly isn’t enough money to truly retire on. With many financial advisers recommending you withdrawing at most 4% of your portfolio in each year of retirement, you would only be able to withdraw around $6,000 out of each account. Good luck surviving on that. (We’re not even taking into account inflation!) You can’t rely on your contributions alone. Those contributions must grow — above and beyond the rate of inflation — to provide for your retirement.

Compound Interest’s Effect on Your Retirement

Compound interest is defined by Investopedia as:

Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.

In short, simple interest is just the interest that is earned on the initial investment. Let’s look at an example, using $10,000 in annual contributions (which is easier for a basic math example than $11,000).

If your $10,000 deposits in two Roth IRAs earned a 7% return, the simple interest for that year would be $700. Your account would end the year at $10,700. On the other hand, compound interest is interest earned on the interest you’ve earned in the past. If your account grows to $10,700 the first year, and you contribute an additional $10,000 and you again earn 7% growth, you would earn $1,400 in simple interest (the interest on the $20,000 in contributions) and $49 in compound interest (the 7% growth of your $700 growth from the previous year). Your account balance would be $21,149. A compound growth of $49 seems really small, and it is to start.

But the growth of your account over time will grow dramatically and eventually surpass what you contribute annually! Here’s a chart of this in action (click for full size):

As you can see for the first ten years, the total growth on your contributions is less than $10,000. But watch what happens: Year / Growth

  • Year 1: $700
  • Year 2: $1,449
  • Year 3: $2,250
  • Year 4: $3,108
  • Year 5: $4,026
  • Year 6: $5,007
  • Year 7: $6,058
  • Year 8: $7,182
  • Year 9: $8,385
  • Year 10: $9,672
  • Year 11: $11,049

In Year 11 your account growth suddenly exceeds the amount you contribute annually. And as your account continues to grow that growth gets larger and larger, eventually adding $66,122 to your account in Year 30. That’s 561% more than your annual contribution. Granted, this is based on a fixed rate of return of 7% for 30 years in a row. The stock market and your investments will not see this type of return. Some years you will see 25% growth, others 15% losses.

But eventually, over time, your contributions will exceed what you put into the account on an annual basis. And just because your account grows $10,000 in a year doesn’t mean you stop putting contributions in — a key component of growth is having a large contribution base. So stay dedicated and invest the full amount every year.

This article is by Kevin Mulligan. Kevin has been utilizing a Roth IRA to save for retirement since 2008.

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