The power of compounding can give you a greater accumulation of funds by saving regularly and early.
To maximize compounding, use these strategies:
- Begin saving early
- Save regularly
- Earn maximum returns
- Minimize taxes
When you start saving early in life, your earnings can accumulate over a longer period of time – giving you a better chance at retirement. If you delay saving, you’ll have to save more later on just to catch up!
For example, assume that Alan and Arnie are twins. At age 25, Alan sets aside $10,000 in his retirement investment account, while Arnie waits until age 30 to set aside $10,000. Assuming a 6% after-tax rate of return, at age 65, Alan will have accumulated over $100,000, while Arnie will have built up only about $75,000. Thus, by delaying savings by only five years, Arnie will have 25% less than Alan at retirement.
Another key to compounding is to save sums on a regular basis.
By setting aside money at regular intervals, over time, more money will be accumulated than by intermittently saving.
For example, let’s assume that twins Alan and Arnie have different savings patterns. Starting at age 25, both twins save $12,000 per year. However, Alan saves $1,000 per month while Arnie saves $12,000 at the end of each year. Assuming a 6% after-tax rate of return, at age 65, Alan will have accumulated almost $2 million while Arnie will have accumulated only $1,860,000. Thus, although both set aside the same amount of money annually, by saving on a regular basis, Alan accumulated 7.5% more than Arnie.
To increase long-term savings, you should seek maximum returns.
Considering your risk tolerance, structure your portfolio to produce the highest potential return. Even a slight increase in annual return can compound into a significantly higher savings balance in the future.
For example, twins Alan and Arnie both save $10,000 per year, beginning at age 25. Alan earns an after-tax annual rate of return of 6.5%, while Arnie earns an after-tax annual return of 6%. At age 65, Alan’s investment account will total $1,630,000, while Arnie’s account will only total $1,545,000. Thus, an annual investment return difference of only 0.5% added up to over $85,000 of additional savings over 40 years.
Finally, minimizing tax costs can significantly increase long-term savings.
Strategies for minimizing income taxes can include:
- Investing in municipal bonds rather than taxable bonds
- Recognizing long-term capital gains rather than short-term gains
- Investing in stocks or funds that pay dividends qualifying for capital gains rates rather than ordinary income rates
- Investing in mutual funds that are tax efficient, typically funds with low turnover, tax-lot accounting and “tax-wise” investment decisions
Let’s look at another example with twins Alan and Arnie. Alan and Arnie both save $12,000 per year and earn a pre-tax rate of annual return of 9%. Arnie does not worry about taxes, so he pays tax at an effective rate of 28% on his investment earnings. Alan takes advantage of tax minimizing strategies and reduces his effective tax rate to 22% on his investment earnings. By utilizing tax minimization strategies, at age 65, Alan’s retirement account will have grown to $2,400,000. At age 65, Arnie’s account will total only $2,100,000. Clearly, tax efficient savings can add substantial value over time.
Of course, the most efficient means of saving for long-term purposes is by combining all of the above strategies.
An investor who pays attention to details can truly take advantage of the power of compounding.
To illustrate the impact of combining the four strategies discussed above, let’s look at our twins Alan and Arnie one more time. Assume that Alan and Arnie both save $12,000 per year. Alan’s savings plan is as follows:
- Begin saving at age 25
- Save $1,000 per month
- Earn 10% pre-tax rate of return
- Incur an effective tax rate of 22%
On the other hand, assume that Arnie’s savings plan is:
- Begin saving at age 30
- Save $12,000 per year at the end of each year
- Earn 9% pre-tax rate of return
- Incur an effective tax rate of 28%
At age 65, Alan’s investment savings will total $3,300,000. At age 65, Arnie’s investment savings will total only $1,500,000. In this example, Alan’s retirement savings are over double Arnie’s savings! This was accomplished by:
- Starting to save five years earlier
- Saving monthly rather than annually
- Increasing the long-term annual rate of return by one percent
- Reducing the effective tax rate by six percent
By saving early and regularly, earning a maximum return and investing tax efficiently, your nest egg can be greatly improved.