Power of Compounding
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“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Albert Einstein
I couldn’t agree more with what Einstein had to say about the Power of Compounding. Compound interest works either for you or against you. Let us see how Jake advises his daughter to capitalize on the power of compounding.
Jake has a daughter Mary who is 17 years old. She has been responsible, working part-time since the age of 16. She received a W2 and has filed her taxes with her dad’s help. Over the year she has saved up $5,500 into her savings account. She asks her father what she should do with the money.
Jake says, “Leverage the Power of Compounding”.
Mary asks, “How do I do that?”
Jake says, “Open an IRA with a brokerage firm and invest the $5,500 into a Roth IRA. Invest the money in an S&P 500 index tracking ETF. Forget about it until you retire at 60.”
Whoa, wait a minute! That is a fully loaded reply from Jake. Let me break it down for you.
What is an IRA?
IRA stands for Individual Retirement Account. The annual contributions you make grow tax free. To learn more about the different types of IRAs please read Understanding IRAs.
What is a Roth IRA?
Roth IRA is a type of Individual Retirement Account where you contribute after tax income. The earnings and qualified withdrawals are tax exempt. If you are 17, you are most likely at the low end of the income tax bracket and aren’t paying much in taxes. Hence a Roth IRA would be the one that makes the most sense given its qualified withdrawal options that are exempt from taxes.
- If your income is below the IRS criteria, you can contribute up to $5500 from per year.
- To contribute, you must have earned the money.
- You contribution grows tax free.
- Qualified withdrawals are tax exempt.
- There is no required minimum distribution age.
What is S&P 500?
What is an Exchange Traded Fund (ETF)?
An Exchange Traded Fund (ETF) trades like a stock and is similar to a mutual fund. An ETF usually tracks an index, for example, S&P 500.
What are some of the popular S&P 500 index tracking ETF?
Power of Compounding
S&P 500 returns are commonly referred to as market returns. When someone says, I beat the market returns, they mean that they beat the S&P 500 returns. S&P 500 CAGR (Compounded Annual Growth Rate) from 1950 to 2014 was a whopping 11.42%. Let us be conservative and say that we only average 8% return per year on the $5,500 invested over the next 43 years. Let us see how Mary’s investment would grow over time. Open Excel, and type the following into an Excel cell: “=FV(0.08/12,12*43, 0, -5500)”. FV stands for Future Value. To understand Present Value and Future Value, and how to calculate one from the other, please read time value of money.
The $5,500 that Mary invested when she was 17 would turn into $169,581.25 when she turns 60. It would be a nice gift for her 60th birthday.
With the power of compounding, you make money work for you.
If Mary chooses to go to college, the money in her IRA is considered retirement savings and is sheltered from the financial need analysis.