The extraordinary power of compound interest
If you are young, you may not think you need to invest or open a retirement account. You probably think it is easier to worry about it five years from now — or ten. You’re wrong. Time is on your side now, especially when it comes to compound interest.
No matter what your age,now is the time to begin saving for retirement. In The Automatic Millionaire, David Bach writes, “The single biggest investment mistake you can make [is] not using your [retirement] plan and not maxing it out.”
Saving is the Key to Wealth
The only way to attain the wealth you desire is to spend less than you earn and to save the difference. The rich are not rich because they earn a lot of money; the rich are rich because they saved a lot of money.
You may be skeptical. I was once skeptical too. But many books I have read on the subject of wealth-building have convinced me — books like Stanley and Danko’s The Millionaire Next Door make it abundantly clear that it is not a high income that leads to wealth — though, obviously, a high income does not hurt — but saving.
Those who become wealthy do so by spending less than they earn. There is no other source of saving, and, by extension, of building wealth.
If saving is the key to wealth, then time is the hand that turns the key to unlock the door. There is no reliable method to quick riches. There are, however, proven methods to get rich slowly. If you are patient, and if you are disciplined, you can produce a golden nest egg that will hatch later in life. It might appear that the pittance you save now could not possibly make a difference, but that is because you haven’t considered the extraordinary power of compound interest.
The Power of Compound Interest
The best way to ensure your future financial success is to start saving today, even if all you have seems like a paltry sum. “The amount of capital you start with is not nearly as important as getting started early,” writes Burton Malkiel in The Random Walk Guide to Investing. “Procrastination is the natural assassin of opportunity. Every year you put off investing makes your ultimate retirement goals more difficult to achieve.”
The miracle of compound interest is the secret to getting rich slowly. Even modest returns can generate real wealth given enough time and dedication … mainly time.
On its surface, compounding is innocuous, even boring. “So what if my money earns less than 3 percent in a savings account?” you may ask. “What does it matter if it averages 8 percent annual growth in a mutual fund? Why is it important to start investing now?”
In the short-term, it doesn’t make a huge difference — but don’t let that fool you. On the slow, sure path to wealth, we need to keep focused on long-term goals. Short-term results are not as important as what will happen over the course of 20 or 30 years.
Related >> Find the best high-yield savings account for you.
Growth of a Single $5,000 Contribution
For example, if 20-year-old Britney makes a one-time $5,000 contribution to her Roth IRA and earns an average 8 percent annual return, and if she never touches the money, that $5,000 will grow to just under $180,000 by the time she retires at age 65, as you can see from this chart:
You can see how the money earned dwarfs the initial investment more and more as time goes by.
If she waits until she is, say, 40 to make her single investment, that $5,000 would only grow to less than $40,000. (On the chart, the red dotted line shows you the total value after 25 years is still less than $40,000.) Waiting 20 years will cost her more than $130,000 in “free” money. Time is the primary ingredient to the magic that is compounding.
Growth of Annual $5,000 Contributions with Compound Interest
Compounding can be made even more powerful through regular investments. It is great that a single $5,000 IRA contribution can grow to more than $170,000 in 45 years, but it is even more exciting to see what can happen when Britney makes saving a habit. If she were to contribute $5,000 annually to her Roth IRA for 45 years, and if she left the money to earn an average 8 percent return, her retirement savings would grow to more than $2 million, as you can see from this chart:
A golden nest egg indeed! She will have more than eight times the amount she contributed. Again, the dark green portion of the chart dwarfs the light green, which is the money she put in.
This is the extraordinary power of compound interest.
Related >> See a guide for Roth IRA rules and requirements.
The cost of waiting one year
It’s human nature to procrastinate. “I can start saving next year,” you tell yourself. “I don’t have time to open a Roth IRA — I’ll do it later.” But the costs of delaying your investment are enormous. Even one year makes a difference. Every year that Britney in the example above waits, she loses one year at the end of the chart. In the first example representing a single investment, waiting one year will cost her almost $14,000 (the column highlighted in red).
Like many people, she may be tempted to think she is only losing the first year’s return, i.e., around $400, but that isn’t the case. She is actually losing the last year’s return ($14,000), not the first. That is a steep price to pay for a single year of procrastination.
The difference is even more dramatic when you look at what Britney loses by waiting a year even though she contributes regularly to her savings. If Britney makes annual contributions of $5,000 to her Roth IRA as shown in the second example, waiting just one year will cost her more than $150,000! That is probably more than her annual income.
There is another way to look at the cost of procrastination. If she still wanted to have a $2 million nest egg at age 65 but she waits five years to get started, her annual contributions would have to increase to nearly $9,500 — that’s almost double! And if she were to wait until age 40, she’d have to contribute nearly $55,000 a year!
How to Get Rich Slowly
You can make compounding work for you by doing a few simple things:
1. Start early. The younger you start, the more time compounding has to work in your favor and the wealthier you can become. The next best thing to starting early is starting now.
2. Make regular investments. Don’t be haphazard. Remain disciplined, and make saving for retirement a priority. Do whatever it takes to maximize your contributions.
3. Be patient. Do not touch the money. Compounding only works if you allow your investment to grow. The results will seem slow at first, but continue on. Persevere! Most of the magic of compounding returns comes at the very end. Compounding creates a snowball of money. At first, your returns seem small; but if you are patient, they will become enormous.
The GRS Introduction to Roth IRAs Series
Understanding how important it is to get started saving for retirement, check out the rest of our Roth IRA series to learn about how to start your Roth IRA, which investments are best, and other general questions about these great accounts.
Part 1: The extraordinary power of compound interest
Part 2: What is a Roth IRA and why should you care?
Part 3: How to open a Roth IRA (and where to do it)
Part 4: Which investments are best for a Roth IRA?
Part 5: Questions and answers about Roth IRAs
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There are 129 comments to "The extraordinary power of compound interest".
One strategy I’ve taken up the past few years, is to max out my 401(k) as quickly as possible. I work at a company in an industry that regularly has layoffs, usually around mid-year and the end of the year. When I figured out that I could max out my 401(k) by August if I went to the max 30% 401(k) withholding my company offers. I figure that that will mostly cover a year’s 401(k) savings in time for a June layoff, just in case I don’t get much more into a plan the rest of the year. I don’t see a pension in our future, and my grandparents lived to be 80, 90, 92, and 95, so I want to squirrel away as much money into tax-deferred accounts as possible.
We try not to dip into taxable savings to cover the withheld funds, but even if we do, that’s moving the money from taxable accounts to tax-deferred accounts, some of which is matched, so that’s OK as far as we’re concerned.
Obviously, we have to have a sustainable monthly cashflow (net income – expenses) and an emergency fund to do this, because having 30% plus health insurance plus taxes taken off the top means the net pay gets reduced by quite a bit for the first 2/3 of the year.
Just thought I’d share this idea — I hadn’t heard of anyone else doing this.
We also put a chunk of money into 529s for the kids when they were babies, so we’re hoping that will cover something if/when they decide to go to college.
Here’s to compounding!
Mr. Sam is doing a similar thing, he is contemplating a job move later this year. So he is maxing out his 401k early at his current job assuming he won’t be eligible at a new job for a few months.
Since I pay the bills, I prefer regular and steady contributions but we are making it work.
I would only caution you both to consider the company match. Maxing out your 401k early in the year could leave money on the table, since company matching is capped per paycheck, and not based on your total contribution throughout the year. To get all of the “free money” your company would give you, make sure you hold back enough of your investment so that you can continue to contribute from every paycheck in an amount that maximizes the company match.
That depends on the particular company’s policies – always a good thing to read carefully. Mine makes a once-a-year match based on the previous year’s contributions, and the cap applies to the annual amount.
I don’t have the option of contributing to an IRA through my employer. Can you do this on your own? If so, should you, and how? I have to admit to being totally clueless on this. I have some money invested, but otherwise I am basically sitting here waiting until I get a “real job” (I’m currently on a graduate fellowship).
My employer cut out our 401K plans when the economy went through its tumble and we all rolled our 401K plans to Traditional IRAs. I dont get the benefit of the company match anymore but Im sure to contribute the max of $5,000 each year. I also opened a Roth IRA because plain and simple, it benefits younger people in a big way, all capitol gains(profit I take from the stock market) grow tax free. I look at it this way, I don’t count on anyone but myself to supply for my retirement and I want to comfortable when that time comes. Good Luck.
Not knowing your financial circumstances its hard to say, but if your employer does not offer a 401k and you earn money more than likely you can contribute to an IRA (and take a tax deduction) or contribute to a Roth IRA (after tax money, but no tax at withdrawal).
I find the Fidelity.com web site very helpful so here’s a link on FAQ (you probably also want to check out the IRS web site). https://www.fidelity.com/retirement-ira/ira-rules-faq Obviously they want you to invest with them, but there are lots of options.
Yes, you can contribute to an IRA. If you are not making much money, then a Roth IRA probably makes the most sense since you are in a low marginal tax bracket. It also means you can take the money out with no penalties if you need it in an emergency. Its really a perfect savings vehicle for someone just starting out.
This is my first year in a “real job” as Sarah says above, and I’ve maxed out the UK equivalent of the Roth IRA – a cash ISA. The max amount allowed is equivalent to $6000 this year, but is going up to $7200 after the 5th of the month.
I plan to max this out each and every year and let compounding do it’s thing, however this type of account is cash based and so (while being very safe) it’s only likely to provide a 6% return or there abouts. It’s possible invest in a stocks and shares ISA instead (and various index and managed funds are available for this purpose), which could probably hit the 8% return used in JD’s example. However I’m concerned about linking my future to share performance. I know you have to look at the market in 10 year chunks minimal, not the current market fiasco, but personally I might be happier to settle for a smaller nest egg which is in no real danger of turning sour when I’m not looking!
@Sarah – you’re in the perfect position to start a Roth IRA. You can do it on your own, and since you’re not making much now, the tax situation works to your benefit. Read up on JD’s series of Roth IRA posts by starting here: https://axis-monolith.live/roth-ira-vs-traditional-ira-which-is-the-best-deal/%3C/a%3E
Yes, you can do this on your own, even if you’ve been uninvolved in the past. And JD’s best line in the post is right on: The next best thing to starting early is starting now.
This post is a classic lesson in leverage. In this case, the “lever” is time: As the length of time increases, the power of leverage increases exponentially…
On a separate, but related note, it sure is a shame that the term, “leverage,” has evolved into a representation of “using other people’s money” for financial gain. Leverage is quite useful and may be used in a context of money, time, knowledge, wisdom, influence, and more…
“Give me a lever long enough and a fulcrum on which to place it and I shall move the world.” Archimedes
I needed this post right about now, so thanks for writing it.
I’m in the middle of ALMOST opening a Roth IRA in order to be able to contribute for 2007, but I was also thinking about skipping 2007, and just trying to max out 2008. Now that I see the difference a year makes, maybe I’ll try to max both! April 15th is quickly approaching…
(Now, of course, picking which one is the hardest part.)
Very good post! Thanks to compound interest, the people who save early do have more retirement savings. Mentally, starting early has a greater impact as well. I’ve found that people who have been putting a couple hundred dollars into their retirement account every month since their early 20s are used to putting that money aside and have no problems continuing saving.
However, those who started later see the benefits much less and have much more trouble sticking to their plans.
As a side note, I’m compiling my Roth IRA posts into an e-book. I wrote this piece as the introduction to that book.
A great post, one which has helped me make a decision between saving money or using it to pay off debt – thank you!
“The next best thing to starting early is starting now”
Definitely the best line in the post. Someone told me the same thing years ago in a different way:
“The best time to plant an oak tree is 15 years ago. The second best time is RIGHT NOW.”
Wow,
I went and found an online calculator to figure out how much my little nest egg will be.
Im currently 19 and I contribute $10,500 annually to my SIMPLE IRA.
40 years @ 8% = 3 mil
45 years@ 8% = 4.5 mil
Hot damn! I love compounding interest
Keonne
Then drop dead at 65 saved all your life ,I worked and saved all my life ,would not do it again,get it spent enjoy yourself ,we are only here for a short time
By starting early, you only need a small portion of your annual salary. Then you can use the rest of your salary to enjoy your today. I’ve been saving 10-15% of my salary since working full time and I feel if I died tomorrow I have lived. You don’t have to be a miser, especially with an early start and some reasonable investing.
Love that calculator.
I’ve taken some comfort in the fact that the 8% year isn’t a sure thing–it makes me feel better that I haven’t lost quite as much as I might have if only I’d started earlier…
I’m thinking this because yesterday a CD of mine came due and the MOST I could get from the bank where that money is sitting is 2.5%. (I know, I know, I should move the money somewhere that would pay more, but electronic banking isn’t close enough to the mattress for me…)
I am new to the retirement plans. Just started a ROTH IRA last month after reading this blog but I still have questions.
My retirement funds is in a target date fund (since I am not experiences with the stocks)but I notice, the more money I put in, the more value I lose because the current stock market is so down.I am starting to question how my IRA suppose to compound? I feel I am compound losing right now.
Should I keep on putting money in there? (It is a 2040 fund to be exact)
Also,what stock you guys would suggest to put my IRA in if not a target date one? I heard many good thing about S&P500 but the price is so high right now. I am not sure if it is worthy to put money into it.
(Thank you for any advise)
I think the number one reason most people don’t invest is because they don’t understand how to invest.
In your case, a target fund is a good beginning, but you can easily create a balanced portfolio with three simple index funds. For example these are my funds and costs with Vanguard where I have my ROTH.
Vanguard Total Bond Index Fund
Vanguard Total International Index Fund
Vanguard Total Stock Market Index Fund
This way you have bought the entire market.
Then you need to decide how to divide the funds.
Let’s say you are 25 years old.
You can have 20% in bonds, 20% international, and 60% in domestic (your Total Stock Market). That’s it, easy as pie.
You can also add a specialty fund, like a REIT or Health Care, but for starters until there is more money in your account, the three funds are a good way to start.
You can read more here:
http://www.bogleheads.org/wiki/Lazy_portfolios#Core_four_portfolios
Last but not least, please remember that you are invested for the long term, don’t sweat it if stuff goes down. Here is a good quote to keep in mind: “If you are not losing money somewhere in your portfolio, you are not diversified enough”.
As an example, my International Index lost 5% last year. Did I care? No, because an index is what a market returns and knew that the international funds would not do well based on the challenges they face in Europe, Japan and emerging markets.
However, this first quarter, while Bonds and domestic stocks did just ok, the International fund shot up to 5.71%. So everything that goes down, goes up, and everything that is up goes down.
Here are some good books to read:
The Bogleheads’ Guide to Retirement Planning
The Bogleheads’ Guide to Investing
Index Investing for Dummies by Russell Wild (funny and good technical stuff)
When you say the more money you put in, the more you lose, is it a set percentage of loss? If so, you may want to review the fee structure and costs associated with putting money into the fund. Could be your funds, even in a ROTH, are front loaded, so they may be taking some percentage (say 5%) off the top in fees. You also may be getting hit with a maintenance fee because you haven’t built up a lot of money in the fund yet. It could be how the paperwork was set up and how the taxes for the ROTH distribution are handled. You can also take a peak on how many shares your money is buying and share value when purchased and compare those to ensure the same amount from your check is used to purchase shares and what that amount is.
In the end though, you’ve only been at this less than two months and March was a losing month so yes, you lost some paper value. If that seems depressing, think of the fact you are buying shares of the fund on sale.
Very nostalgic post, J.D. It took me back to old skool GRS.
There’s a reason why posts on the power of compound interest are usually well-received. Most people don’t realize how powerful a wealth-building tool it is! Even if they think they do, it usually takes an illustration like that post to make them truly realize what they’re missing out on.
One more thing. There’s a flip side to compound interest. That flip side is compound interest that you are CHARGED for purchases on your credit card. Avoiding that is as crucial as taking advantage of earned compound interest.
What I don’t get is where the 8% comes from? Over the last 10 years the market has been flat. If I invested $5000 ten years ago I would have a grand total of probably less than $5000 because of fees. I’ve been looking into where I should put my retirement money and it’s not easy.
Index funds my dear Shelton, index funds, if you can help it stay away from high fees actively managed funds.
Here is why:
Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account.
If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.
In this “flat” market of ten years with nothing but index funds I have more than doubled my retirement account which is now triple the value of the money I put in over the years.
Just because someone can show mathematically that $5000 put in at year X is now worth $5000 in year X+10 is no reason to believe that $5000 put in every year for 10 years starting at year X will only be worth $50,000 at year X+10.
We’ve started as early as we can — 23 and 22. One of the things we are going to request from our friends and family when we plan to have kids (several years down the road) is money to put into a custodial account. Imagine what $1,000 at Age 0, given 60 years to compound, would result in? We’ll also do a 529 plan, but I really want to save $1,000 and see what happens.
For the curious, at 10% return, that’s $304,481. 🙂
I’m a recent college graduate with student loan debt. I was planning on quickly paying off my loans and then start saving, but now I’m not so sure. What should I do?
There is no “wrong” answer IMHO though many may say different. Paying ahead on the debt removes a burden from you quicker and if you then turn all that money around and invest it you’ll probably “catch up” pretty quick, assuming you have the discipline to do that. On the other hand, if you got a company match, you could put in enough to max the company match, then all the rest towards the loan extending the loan but gaining “free” money. If you get no company match, than there is the idea that some money saved will help many years down the road and would $2000 a year make a better impact towards your future or towards your debt?
There are pros and cons to any of these choices, but a big part of personal finance is the personal part. My recommendation would be as soon as you have a full time job that pays more than you need to exist, you start saving a portion of it for your future. It gets you in the habit and it helps your future self.
I’ve been on the fence for a while about whether to start a Roth IRA now or in a couple months when we move into a new house. I think it’s going to be June when I start them for us, because then we will be sure that we have enough money to cover our down payment and our closing and moving costs. I’d hate to have to dig into the Roth for extra funds after I open it.
The real question: is it better for my wife and I to fund separate Roth’s or are there any advantages to setting up a joint?
Daniel @ Young and Frugal
Great site. I’ve got a question I’d love to ask, specifically about the Roth IRA:
Say a person had earned income in previous years, and contributed to a Roth IRA… but this year had no earned income, for whatever reason. What’s to prevent the person from going ahead and contributing to a Roth this year as well? It’s not declared on the 1040 (which would show the earned income problem), so who would step in and say “no”? Somebody way down the road, at the time when the Roth is tapped decades later???
I’m sure there’s a good argument against the above — something obvious that I’m missing. Can anyone fill me in?
@Daniel@YoungandFrugal: You can’t have a “joint” Roth or Traditional IRA. IRA = Individual Retirement Account.
So fund one, and put the other person as the beneficiary if you die. Fund it to the max, and then open up a second one.
What a great article. I wish I could turn the clock back, which I cant, so instead I’ll wish to win the lottery to make up for lost time 😉
@Daniel and No Debt Plan: A more fair way in the possibility of divorce is to fund one for you and one for your wife equally, instead of fully funding one and not the other. Hopefully this wouldn’t be an issue, but as they are individual accounts, one can’t be too safe.
Whenever I read posts like this, I get an intense sadness, because I feel like I am already behind everyone else who is posting here. I am currently almost 30 and I have never been in a financial situation where I can contribute to a Roth IRA or 401(k) account. Part of this is because I have been in school for almost a decade now (4 years undergrad + 5 years grad school) and a student’s salary is not enough to support any type of saving. I feel like I’ve made a stupid decision to further my education and attempt to do something I love to do (post-secondary teaching) instead of investing in my future. The worst part is that I’m actually educated enough to understand what compound interest actually does, but am powerless to do anything about it.
You are where you are and first priority is survival. My only recommendation is if you have a steady check coming in, peal some of it off to a separate account as automated savings you don’t touch or only touch in an emergency, even if it’s only $10 a check. I have always found the greatest barrier to savings to be the initial set up, of automatic withdrawls, of opening new accounts, of saving for specific items, etc. Once the account is open, even if you move and have to set up new accounts, you are already in the habit of taking a bit and saving it and you will be inclinded by habit to do that again. Once accounts are open, adding more money per year as salary goes up doesn’t seem as hard, it’s a minor change. In other words I’ve found it easier to widen the trail after I’ve blazed it.
Sheldon wrote: What I don’t get is where the 8% comes from?
Excellent question, Sheldon, and worthy of a follow-up post. Long-term, the market has increased in value at an average annualize rate of X%, where X is 6% or 8% or 12%, depending on how you’re making the evaluation. (In the post that comes later today, the author uses 13.4% as his number.) I choose 8% because it seems reasonable to me based on my research. But you’re right — this topic deserves a deeper discussion. It’s a part of basic financial literacy. I may even try to write about it for tomorrow! 🙂
@Jim E
Though your IRA contributions aren’t declared on your tax return, they are reported to the IRS. You should receive a statement from your investment firm every year. The IRS gets a copy of this, too. Besides, it’s never a good idea to try to pull one over on the IRS. The consequences are dire.
@JD:
Got it: the IRA contribution is reported to the IRS, who presumably will check the contribution amount against what the tax return says is allowable. Simple answer to a simple question; thanks!
@Jamuraa
Don’t be sad!
Don’t dwell on the past. Instead, focus on what you can do now or in the future. If you’re still in school, you might not be able to contribute to your retirement. That’s okay. Your investment in your education is just as valuable. It’ll allow you to catch up in the future. Just be aware of the power of compounding, and seek to use it to your advantage when you’re able!
Personal finance is all about trade-offs. And while the power of compounding is not to be ignored, sometimes one has to opt for another choice, such as education.
This was a great article.
I was thinking of a way to turn all of my nephews attention to personal finance without putting them to sleep, the oldest one is going to be 17 in a month.
I sent them a link to this article as well as a copy of ‘The Richest Man in Babylon’.
My hope is that even if they just pay lip service to this, the fact that they know this info will be indicting to them and help them to get back on the right path.
Jamuraa,
I too was in grad school and my husband and I did not contribute to anying till we were in our 30s (post-secondary teachers). The lessons in frugality you are learning in grad school will be useful for the rest of your life! We have contributed every year since we started working–yes, you are losing your 20s as a time to invest, but there is no substitute for the great job of teaching. We want to work forever!
BTW, will be starting my own blog on this very subject next summer–be on the lookout!
This is so frustrating to me, because I don’t have a 401k anymore through the small business I work for, and I do have an ING account for long term savings, and I rolled my 401k from a previous job into a trad. IRA that I fund monthly, automatically. I save a little over 30% of my take home every month, but I am 28, a graphic designer, and I am no where NEAR maxing out my IRA. And I don’t really see a way to cut corners to get there. Charts like that don’t make me feel good about what I am doing, they make me feel bad that I am not doing more, and time continues to slip away.
I love my Roth IRA. One thing that you also need to remember at this time is Don’t Panic!
I have been getting questions about whether it is time to cash out a retirement plan before the market crashes. The answer is NO.
As mentioned in this great post, the idea is to keep investing for the long term. And in the long term, the stock market gains…
@Sam:
Investing really isn’t that frightening once you start doing it. If you have a pension, that will be invested in stocks and shares, not in cash because the return on cash is dangerously low over the long term. Nothing is risk-free.
I wouldn’t normally self-promote, but I have just written a series on investing in stocks and shares ISAs for beginners, and I’m sure you can become comfortable with a suitable level of risk.
JD-
Possibly your best blog yet!
I always wish I had started saving earlier…who doesn’t. But I’m glad the wife got me to start when I did. It’s never too late. As you said, don’t dwell on the past…mentally it will make it tougher to invest. Focus on the future and you’ll mentally be much more ready to start today.
Mrs. The Point – I have similar concerns and sometimes feel like I’m throwing my money away investing in my IRA which keeps going down lately. Which is why I haven’t fully funded it for 2007 yet and am still on the fence about doing so.
The thing that helps me, is remembering that you are buying cheaper shares now since the market is down, so you can buy more of them with the same amount of money. Buying more shares should make a bigger difference when the market goes back up!
You have to be in this for the long haul, and ignore bad times. But it’s something I struggle with too.
Anyone else have advice for those of us who are having a hard time throwing more money at an IRA that is losing overall value?
My question: You are talking about “compound interest”, but seem to be referring to investment accounts.
As I understand it, “compound interest” refers to a fixed interest that is guaranteed, and builds steadily over years…like the interest on a savings account. But with a 401k or IRA, neither the principal or a profit is guaranteed to be there.
I understand the point being made, and agree. But is it correct to call investment income/profits “compound interest”?
What most people don’t realize is that the majority of the long term returns on stocks came from dividends. With most stock dividends paying less than 2 percent right now it makes sense to put your money into safe bonds.
With safe bonds you do not have to worry about market fluctuations because your bonds will come due at face value at maturity.No one seems to place much value on not loosing money.
In reality if you lose less, then you do not have to take the risks to make more. Bonds provide that alternative to risk taking, which can become an addition in and of itself.
We have successfully used this strategy for our selves and our clients. We finally wrote about it in our latest book: BONDS: The Unbeaten Path to Secure Investment Growth.
It really doesn’t matter if you invest in bonds in an IRA or in a regular cash account. If you are in the 25% marginal tax bracket or higher, you can purchase muni bonds and not pay taxes on the income.
View education as an investment in yourself to enable you to get a job that you love and provide yourself with the intellectual flexibility to take advantage of opportunities and changing times.
I started to write about bonds from the perspective of an anthropologist, my graduate school training. It has served me very well.
BondGuru
That’s a great question, Susan. Compound interest and compound returns are twins. The same principles apply to each, but they refer to different things. In the post, I tried to use three terms: compound interest, compound returns, and compounding. Though the title does say compound interest (because that’s the term most people are familiar with), in the post itself, I’ve tried to keep the terms in their correct locations. I may or may not have succeeded. 🙂
I am not so old that I don’t remember when I was that age, and people kept telling me save save save.
But did I listen?!?
I’m kicking myself now!
Lisa
I’m aware of how compound interest can make you wealthy, but my problem is that it takes all your life before you are wealthy.
The people I read about in the Millionaire Next Door were old dudes before they became wealthy. And they spent the majority of their lives working well over 40 hour weeks at lame jobs and living an extremely frugal life.
I’m all about being frugal, but I just can’t get myself into the idea of pushing myself to save 10 percent of my income when there are so many more attractive things I could spend it on like school and travel. I nearly died a year ago and my body already feels old. I do want to have a home and food and basic necessities when I’m retired, but how am I going to use millions of dollars when I’m an old lady? And what if I don’t even live that long?
Oh Heather!!! you are already a winner, you are still around.
Look at it this way, there are no instant riches, that’s how suckers lose their money. Say you are going to make it to old age anyway, is it really that hard to put 10% away and have security in your old age? You don’t have to start with 10%. Start with 1% then 2% the next year and so on. Instant gratification is not everything, will you remember all the stuff you spent money with nothing to show off other than a receipt from Goodwill?
Also, you don’t have to aim for being wealthy at retirement. I don’t know if I will be able to afford a cruise around that world at age 70, but my number one priority will be TOTAL SECURITY. What does that mean? It will mean that I will have enough to cover basic life: housing, healthcare, food without having to choose one over the other. The rest is just stuff, you have to find fulfillment in your life, money doesn’t buy that, but it does buy security.
I totally understand that when not enough income comes in it’s tough as hell, so start with the simple stuff, like trying not to create debt or carrying debt, have a $500 emergency fund, then try to add a little at a time, until you are secure enough with what you have and then start investing. People think you need to do it all at once, but securing ones future is like a staircase, one stair at the time.
Heather-
It’s too bad you feel that way. Sometimes pushing away small immediate gratifications mean you get to experience such great ultimate rewards.
Of course, most of the world agrees with your immediacy, and as such, we have 7 year car loans, 5 years “no interest” furniture loans, and bankruptcy rates increasing every year.
Having a nice nest egg as you approach retirement is a great thing but what if you die right before you retire? That would truly suck. All that money that you had planned on spending in your golden years would go unused by you.
That said, I’m still planing on saving money every month for my retirement 35 years away. I just really hope I’m not shot or run over at age 65.
This would make a really chilling twilight zone episode actually. Have a character who spends his/her entire life saving money for a wonderful retirement die of a heart attack right before they retire.
I’d rather die with money in the bank, then be old and standing in line at the food bank. It’s as simple as that.
Heather, I hear you. (Brian, I understand your response, too, and agree with it generally, but in response to Heather, I think it was a bit glib.)
Deciding where to draw the line between enjoyment in the moment vs. saving for the future is a very personal decision that will be different for everyone. No matter what you decide for yourself, though, one way I’ve read which might help you is to do a budget (as rough or detailed as you want), figure out what your monthly expenses are, and with the remainder, allocate a certain percentage of it for savings and a certain percentage for pure FUN.
That way you’re kiling two birds with one stone. You know you’re saving, and you can spend what you’ve already decided will be your “enjoyment dollars” without feeling guilty in the slightest. 😉
Hope that helps!
Yes it would suck to die (just before retirement or otherwise) but at least you can then leave your fortune to those you love and insure that they will be able to attend college, retire and otherwise have lives without financial worries.
If not to a love one then leave the money to a cause or charity that you care about. At least something that you believe in will be able to prosper due to your efforts.
I chose this route over leaving my survivors with a pile of bills and otherwise in the lurch.
Then again, maybe it’s more satisfying to give that money to GM, Countrywide and Toshiba on the installment plan.
maybe mine was a bit harsh, but it disgusts me to see how everyone has an over-active tendency to only look at what they get at the moment. This board is called “get rich slowly” for a reason. Wealth, at least lasting wealth, is not immediate. It’s made over time. When you are able to delay pleasure, the pleasure ends up being that much stronger.
And to the question of “what if i die before i retire”? Ummm…I doubt you’ll think too much about the fact that you didn’t have a chance to spend the money you saved….you’ll be dead.
Justin, this morning you asked:
“I’m a recent college graduate with student loan debt. I was planning on quickly paying off my loans and then start saving, but now I’m not so sure. What should I do?”
When I was in this position, I split the difference and paid the loan payments as they came due, but also saved for retirement. I wasn’t able to max out retirement, but I didn’t want to lose out on the compounding advantage. Ultimately it depends on your individual situation factors like: the amount of your loans, the interest rates on your loans (how oppressive are they?), your opportunities to save (pay rate, access to 401k). But I can share that my loans are long gone and forgotten and meanwhile I can already see results of starting early, even taking into account the current turmoil, and that I started during the tech bubble years, and that I didn’t max out, and that the contribution caps were much lower in the 90s.
But for those grad school folks, it is worth it to be working toward your goals professionally too. My husband spent years in grad school, started contributing when he started working full time and we have about the same amount now – he was able to save larger amounts – higher limits when he started too.
If you start when you can, you are already ahead.
@Heather:
I was pretty much “live for now” before DH and kids, so I get where you’re coming from. However, I hate to think of anyone working at 75 to pay for basic living expenses. You can enjoy your life without living like there’s no tomorrow. My dad pointed out to me early that if you contribute just 1% to your paycheck to a 401(k), you won’t even notice, because that amount is removed before taxes. Suppose that 1% is $50. But you’re probably only reducing your net take home pay by $35. And you can increase it as you can.
I don’t think our lives are bleak because we’re frugal. We spend money now on what we care about (travel, foreign languages, music, art, education, theatre, indoor and outdoor activities, food, minor-league hockey games) and not where we don’t (cable, 1st run movies, lots of new name-brand clothes, lots of toys, impressive home and cars, dining, junk food). Your priorities will be different, but there are likely places where you can cut back that won’t feel “cheap”.
BTW — I watched my aunt die of ovarian cancer just 2 years before she and and my uncle were going to retire and travel and volunteer. I would prefer to have enough money to retire much earlier, myself, just in case!
@Brian:
“maybe mine was a bit harsh, but it disgusts me to see how everyone has an over-active tendency to only look at what they get at the moment. This board is called “get rich slowly” for a reason.”
I agree with you completely. It’s just that in response to any **specific** person, we never know exactly what their situation is, so I feel it’s not fair to judge them. Especially when Heather said “I nearly died a year ago.” We have no more info. than that, but I can certainly see how a near-death experience would make someone want to appreciate life to its fullest in the moment.
But in general terms, I think you’re absolutely right.
“And to the question of “what if i die before i retire”? Ummm…I doubt you’ll think too much about the fact that you didn’t have a chance to spend the money you saved….you’ll be dead.”
LOL–good point! 🙂
@Sarah
I have my Roth IRA with Dodge and Cox. You’re in luck because they just reopened their Dodge and Cox Stock fund to new investors. It’s a value fund and it has done very well for me and has very low expenses. (800) 621 3979.
I have my traditional IRA with T Rowe Price. I have it in their Equity Index 500 fund. They have a very low minimum if you add to it every month (dollar cost average).
800 225-5132.
Invest in either of these funds and you will be able to sleep at night.
Hope this gives you some ideas.
Best of luck.
Thanks for all of your answers to my question. I guess it was written in haste, because I do think it is valuable to save oney and plan for retirement, I’m just not so much worried about starting right away if all I’m losing is a chance to be a millionaire.
I do want a decent nest egg, something like a few hundred thousand dollars that could be put into CDs or bonds so that I could live off of the interest. But to start now on saving for that would mean I would have to get a full time job and leave my son with someone else. To me it is worth giving up many years of compound interest for things like that…children, family, education, etc. To me, being a millionaire at retirement is nothing in comparison to reducing my time at life-sucking jobs and enjoying time in the present. I’m not saying I need to get into debt or spend beyond my means to live a fullfiling life.
My problem is not that I spend too much, it’s that I don’t make enough (our family income is around the poverty level). With little income, I have to make decisions like choosing between saving for retirement or buying organic foods for my baby. Or between visiting my husband’s family or saving for retirement. To me, the organic food and visiting family is more urgent and the retirement can be saved for later when my son is older and I can work more hours. Or after I’m more educated and can make more money per hour.
The main point is that although I believe having a retirement plan is important, I don’t see the value in being incredibly wealthy at retirement, especially when it means compromising a peaceful and fulfilling life now.
And even though I say that, I still love this blog and appreciate all the info it has provided!
Peace.
Great post! I’ve linked to it on my blog.
Heather, there is a distinction between being rich and being independently wealthy. If you are rich, you have a lot of money. If you are independently wealthy it means that you live within your means and are not dependent on others.
You might enjoy the book Your Money or Your Life by Joe Domingez.He talks about the trade-offs people make between having time and doing what you want to do, and making money. Your choices are reasonable, you just have to understand the consequences.
Also, if you get in the habit of saving even a little on a regular basis, it will come easier to you.
BondGuru
Heather –
I highly recommend you check out some investment calculators which are linked to throughout this website (or just google ‘retirement calculator’). A few hundred thousand dollars will probably /not/ be enough money saved if you intend to just live off of the interest. If you have $300,000 saved up and retire at age 65, it will likely only last you 10 to 12 years (even if you live off of the equivalent of $40,000 or so per year), if that long.
This website
http://moneycentral.msn.com/retire/planner.aspx
estimates that if you have a little over $300k at age 65 and retire, you’ll run out of money around age 79 – assuming that the government gives you $13k per year in social security (which may or may not happen by the time any of us retire!). Without that $13k per year, your money will run out at age 73. 8 years is not a long time to live on $300k in savings! So, a million dollars or more at retirement isn’t really “wealthy” for people who plan to live more than 10 or 15 years, especially if they would like to travel or anything like that in retirement.
I’m not trying to bring you down, just trying to show that many of us who are young grossly underestimate how much retirement will cost! (I’m 23, and I include myself in this category.)
I’m 54 now. Man I wish I had listened to someone when they told this to me when I was 24. My wife and I have started saving but we are way behind. Better late than never but oh man. What a waste of Money.
Hi, I discovered your blog very recently and have been benefited to a large degree due to the learning I extracted from it.
In this post,should we not talk abt the impact on inflation and hence the real interest rate. for example, in India the inflation is much higher than the savings yield, and hence even after compounding, the investor would be losing wealth although gaining in currency. The interest rate is also critical while thinking about any investment. What are your views on this?
OK, here’s a question: should I be saving my money or using it to pay off my debt?
Okay, I’ll bite.
Do both.
I carried debt, made some dumb choices, but through it all I saved 10% or more of my salary into a retiremenet account no matter how many times I was tempted to suck up the penalties and tap it. Mathematically was that the “smartest” thing to do? Probably not, it probably would have been smarter to have used it to pay off my debt and then turn around and save the “debt snowball” value into retirement. Would that have been the way it played out? Definitely not, I would have justified myself into spending the money and would have been sitting there years later with no real retirement savings. Where you are in your discipline and your financial savy, you’ll have to decide and run the numbers and determine if you and yours can stick to your guns and follow the plan.
How much are you paying in interest on your debt?
If you are talking about credit card debt, you are almost certainly better off paying it off than investing the money and continuing to pay interest on your debt.
If you have a mortgage at under 5%, your chances of doing better by investing the money are pretty good over the long haul. But that requires that you invest in volatile investments with the risk of losing money, like a stock index fund. The likely return on your investment after deducting the 5% you are paying in interest on your mortgage may not really justify that risk.
One other thing to note is that Roth IRA currently has income limits, so it is also advantageous to start investing early in your career before your income rises above the Modified Adjusted Gross Income (MAGI) cap.
Hi. Those investment calculators always seem to overstate what one needs. Personally, I’ll be happy to die broke (I come from a long line of “don’t expect an inheritance” folks).
Just think about how much less people would need to put away for retirement if we had a reasonable national health care option. I certainly hope we develop one soon!
@elisabeth
So you’re happy with other people taking care of you. As long as you don’t have to take care of yourself.
I’m sorry, but I rather you die broke before having to pay for your health care.
This is coming from someone who lived under a National Health Service.
This rational makes me sick.
@plonkee
That would be very useful – although some 90% of the US advice around here is directly transferably to UK finances (see today’s article for example, makes plenty of sense!) I would definitely feel more comfortable reading a UK perspective on the stocks and shares ISA. A friend of mine is doing the same thing as me only contributing to one of those rather than cash, and he’s sweating a little at the moment. However I think we both know long-term his investment plan will beat mine!
Mike Kingscott, here is the answer. Yes!
@ elisabeth –
There is a difference between “dying broke” and dying with a huge amount of debt that someone else will have to pay off for you. Leaving that kind of debt to loved ones or society isn’t fair to anyone. And that national health plan? You’ll still be paying for it, just through higher taxes instead of through your insurance premiums and co-pays. Nothing is free. (But then again we all know the US government is an excellent money manager and is known for making bureaucratic decisions that are favorable for the general public, right? Oh wait . . . )
@ Mike Kingscott –
Check out Wesabe.com. Its a personal finance site with tips and information, but includes tons of message boards where you can ask questions of other members and explain more about your personal situation. (No one can answer your “save or pay debt” question without knowing some more background information. Or rather, people can answer, but they won’t know what is actually best in your situation.)
Relax — I don’t have any debt now and don’t intend to leave any when I die broke. BUT I’d still rather have all of us taxpayers paying for health services for all of us than some of us paying for the emergency room and other costs of having so many people unemployed. I suspect JD doesn’t want to turn this blog into a discussion of national health care, but I will say that I think I can get rich slowly even while I live in a society that doesn’t let anyone suffer from a lack of health care.
The differences in the returns are truly amazing. And part of me agrees with elisabeth on the health insurance question… in the hospital where I work part-time we recently had a patient who stayed just over a week in intensive care and ended up with a bill of well over a million dollars, because of the overwhelmingly high cost of his life-saving treatments. Unless he was independently wealthy, which he did not appear to be, this illness could likely lead to his financial demise. Sobering…
Jerry
http://www.leads4insurance.com
That chart makes a fantastic point! If only someone had shown me this chart in high school.
Saving money is great. Investing money is wise. Starting business is a MUST to became richer…remember is not money that make you rich is business skill what really make you rich. It’s a lifetime learning thing…
I am convinced if people truly understood the principle of compound interest that a lot of people would be wealthy, and we wouldn’t be in the credit crunch we happen to be in. It was Albert Einstein said it is the most powerful force in the universe there is something behind that.
Brice
http://financialzip.com
Thank you for your blog post about the effect of compounding interest. I cited your article in a blog post of my own regarding what to do with money that is made online. In my mind, I believe that money made online should be transferred, through EFT, into a bank whose presence is most pronounced on the internet. ING Direct comes to mind.
http://www.shop-network.org/blog/internet-banking-makes-dollars-not-cents/
I wrote a primer on the power of compound interest, which you can find here:
http://www.btgnow.net/2008/08/compound-interest-is-free-money-part-3-time-is-money-friend/
Time is definately of the essence when you consider the power of compounding. I’m still working on a way to figure out what to do if you hadn’t started investing early (and I think I have a prety feasable idea). Hopefully one day I’ll crack the code and everyone can be millionaire, not just the early birds!
Einstein did not develop the theory of compound interest. That he did is a myth.
Read BONDS: The Unbeaten Path to Secure Investment Growth to find out how to make compound interest work for you.
You may not make 10% on your money, but you won’t lose money either if you invest in safe bonds.
@Hildy:
Yes, actually you can lose money, just not the way most people think:
Safe bonds such as Treasury Bills (bonds backed by safe governments like the US or Canada) will be safe in the sense that they will likely not cause you to lose any of your initial investment. Of course, there are many bonds that are incredibly risky as well, so an investor shouldn’t start thinking that ALL bonds are safe investment vehicles.
Even with “safe” bonds, however, there is something called interest rate risk: it’s the risk that inflation will rise faster than the interest rate the bonds are offering. For example: if you bought a bond today that paid 5% per year for 5 years, and for the next five years the annual inflation rate was less than or equal to 5%, you’d either make a little bit of a positive return (if inflation is less than 5%), or you’d be just keeping pace with inflation (5%). If the annual inflation rate during those 5 years is GREATER than 5%, then your bond payments are lagging behind inflation and your are losing purchasing power.Inflaton is outpacing your returns, and you are in a very real sense losing money in the form of lost purchasing power.
The value of your bond will also have decreased if you tried to sell it to compensate the person you sold your bond to.
The book you pointed out sounds interesting though, I’ll definately have to to check it out.
You are correct in stating that there is a risk of inflation in every investment, including bonds. Interest paying bonds, however, soften the blow if the interest can be invested at the higher rates. That is how an investor gets growth in bonds- through the investment of interest and the reinvestment of returned principal at higher rates.
For the serious bond investor an even more serious problem is the decline of interest rates. Though the bonds might appreciate, all the interest is invested at lower rates, and maturing bonds must be reinvested at lower rates. This risk is exacerbated by keeping your assets liquid and in short-term maturities. Investors tend to overlook this problem and focus on the effects of inflation.
In BONDS: The Unbeaten Path to Secure Investment Growth, we outline different bond investment strategies for many investment situations and types of investors.
I quoted you on my blog the other day and credited you and everything.
“The rich are not rich because they earn a lot of money; the rich are rich because they save a lot of money.”
Please let me know if that is not ok. This was an excellent post that I had to pass along!
The rich have money for many reasons, Liz. However, they will remain rich if they do not understand the power of compound interest. They must save enough to continue to replenish their depleting capital.
Those of us who start out with no money must save. If you start early enough, a small amount of money can make you a millionaire.
The savings must be invested in bonds or another investment that provides a stream of income. I prefer bonds because bonds pay interest without any additional work on my part.
Conservative, plain vanilla bonds are less risky as well. The income from the bonds or other investments must be re-invested to have growth. The growth comes from the compounding of the income, paying interest on interest.
This is different from putting money into stock and hoping someone will buy you out at a higher price. It is the stalactite hanging from a cave wall, continuously dripping water onto the stalagmite below.
Thank you for posting my statement on your website, Liz.
Please check out my book BONDS: The Unbeaten Path to Secure Investment Growth, Bloomberg Press, 2007.
I prefer equity fund or mutual funds because the higher returns. Government bonds and Treasury bills are also good if you need to invest it short time. However, time is also a major key player in compound interest so start early!
You have to work for the IRA the first 4 months out of the year, just to pay income/sales tax for the year!
There is something very wrong about that…
I mean the IRS…
There is a new class of bonds coming to market. They are municipal bonds that are taxable and will grouped under the title Build America Bonds (BAB). They are suitable for retirement accounts and for people seeking taxable income. They will be municipal bonds, supported by your taxpayer dollars and revenues received by municipalities. The Federal government will be supporting the issuance of these bonds through tax credits. They are new, so the yields may be attractive.
I’m 19 and putting myself through school, I want to start saving what other instruments earn compoud interest. I’m also putting a little into a 401k but I don’t plan on staying with this company very long what will happen to that money? And should I stop contributing?
Hi Thomas,
Plain vanilla bonds will enable you to earn compound interest on your savings. It is a simple answer, but also quite complex in executing it.
After you leave this employer, you can roll you 401K into an IRA and invest the money yourself.
Why isn’t anyone talking about equity indexed universal life insurance?
wow what a eye opener
i’m 26 years old & i just closed my first business
i owe about 11000 and at the moment spend more than i earn, i have a plan to eliminate my debts by the end of the year however i work for a min wage and would like 2 go to school to get my degree it just seems so hard building an emergency fund save for IRA for school and for a home down payment-where i live houses r very expenses(Israel)
what to do first?
I HAVE A QUESTION…SORRY FOR THE IGNORANCE, BUT HOW OR WHERE DO YOU START A COMPOUNDING ACCOUNT? AT YOUR LOCAL BANK? IF SO WHAT IS THE ACCOUNT CALL?
I came across this site recently http://www.inspiredtosave.com whilst trying to each my kids about compound interest and why they should save from a young age. It seems to have sparked their imagination…
I’ve been investing in my Fidelity IRAs since I was 18. I am now 40 years old. I’ve been contributing $3000 annually for 22 years.
I have put more than $66,000 into my IRAs and my balance now stands at $104,000.
The “Magic of Compound Interest” is a crock of sh*t in the real world. Nobody makes a consistent 8% interest annually.
Where do I sign up for 8% interest..?
I understand the value of compound interest. It’s a great thing, if one can get an interest rate worth a darn.
But I’m really tired of example after example being posted online showing regular folks getting annual rates of 7-10%.
Sure, it illustrates the value of compound interest. But this isn’t 1983 here. The best CD rate I can currently find is still under 2%.
So, while using high interest rates is a good way to show the effect of compounding, the examples are so unrealistic as to be near worthless.
Barbara Fussmuller wrote that she is tired of being told she can get 8% on her investments, when all she sees is 2 percent on Certificates of Deposit. Actually, Barbara, most professional investors are not getting 8 percent either, as we can see from the underfunding of public pension plans. However, you can get 4 percent on some high quality corporate bonds and sometimes better than that on high quality taxable municipal bonds. You do have to look beyond the C.D. however.
Thenks for writing this post. I needed this post right about now.
I’m in the middle of ALMOST opening a Roth IRA in order to be able to contribute for 2007, but I was also thinking about skipping 2007, and just trying to max out 2008.
It’s really difficult to promote the value of investing early for retirement here in the Philippines. Most of the people here tell me that it’s not their priority now. It really is frustrating because I really would like them to be prepared for their retirement. Most people here over the age of 60 struggle financially and even still work full time for them to get by. It is heart breaking. Reading this is somehow a breath of fresh air. I wish a lot of people here read this.
Please show me an IRA that pays 8% interest?
My Roth at Vanguard invested in index funds returned 7.9% in 2014.
My 401(k) at work only returned a 5.75% due to the high fees in 2014.
Hi Mikey,
You are confusing two things. An IRA is a vehicle for holding investments, stocks or bonds, either as individual holdings or in a portfolio of stocks or bonds created by a mutual fund or ETF. The IRA holdings create value either by appreciating in value or paying interest. In 2014 only very risky assets are paying 8% interest. Risk means that you have a substantial chance that you may lose the invested principal – the money you put into the investment.
The only problem with saving for retirement is. You have to spend the money eventually. Say you have 1.5 million dollars in savings and somehow getting 5%. You can live of the interest say 70000.But then you will have to pay tax on that say 15000 so your living of 55000. Which is not bad.just over 1000$ a week. Now a problem I see is money does not appreciate in value. So say at the end of 30 years of saving with inflation your money might not be so much. I think it’s great thing to do until u can buy a house outright and save on interest then start again meanwhile buying a investment property
While i enjoy a good #TBT post, none of the images are showing on my computer. Just to warn you because they’re kind of important.
A tiny, little glitch, but the images are working now.
Thanks, Beth. Hope you have a great day! 🙂
Thank you 🙂 I liked this post — it was worth a re-read.
I just don’t believe that investing in retirement and investing in *traditional retirement is mutually exclusive, and this article (and many others on retirement) makes it sound as if it is.
It feels too forced and artificial to me. The repeated message I get is “you are incapable of taking care of yourself without help from some 3rd party, rich uncle, so you’re a fool if you even try.” It leaves a hint of “sell your soul” aftertaste in my mouth and maybe I’m just being melodramatic (I do that sometimes), but I wouldn’t feel the need to if that same voice wasn’t so much louder and consistent (and insistent) in the PF world. I understand that I tend to lean more towards the “personal” part of personal finance than others, who are more comfortable with interweaving their finances with more economical (market investments) and private (insurances) threads.
I would be very interested in reading stories and articles about alternative retirement investing methods. Both about theories in practice, and accomplished ones.
* The most propagated methods which just so happen to greatly benefit the most powerful corporations in the world, while providing the most ideal tax scenario for the government
This is a timely post for me. I am in need of some home repairs and am considering cashing out an Roth IRA to do so. The idea of stealing from the “future me” makes me cringe, but there are reasons I am considering it. I would love any advice or input from GRS readers. I initially tried to refi my house, worth aprox $165,000, with a current mortgage payoff of about $60,000 and wanting a $40,000 cashout for a new heating system, tile for 3 rooms, ect. The problem is, to get better estimates for tile, I removed the existing carpeting, for painting, removed wallpaper, etc. My banker will not send an appraiser out to value the house “with no floors”. She told me to find the money to make the repairs, then get the loan. My Roth has never performed particularly well, and the penalty for withdrawing early is still less than the loan fees and lost rebates for installing the heat system. I will only get the new heating system out of the Roth cash-out, but that is my only real need, the rest, like the tile, is “wants” that I can save for. I currently have a 5.25 interest rate, and would be getting 3.75, so if I didn’t need to cashout, I don’t know that I would even refi. Advice anyone?
We are currently refinancing from 5.25% to 3.75% simply for the savings, so for us, the savings is worth it. But, since your banker won’t send out an appraiser, it is probably a moot point.
As far as taking from your Roth, I think you can always pull your contributions with no penalty.
I was told that you pay income tax on any money earned by your fund, but any withdraw at all from a retirement fund gets hit with a 10% federal govt penalty if you are not yet 59 1/2″. But the Roth investment agent could have been lying to me, he seemed almost deliberately confusing!
In high school I took such useless math classes, but none that taught basic personal finance. And both my parents were non-investors, so I was totally ignorant about it until I started reading books like Dave Ramsey’s when I was in my early 30’s.
Of course, I had some in a teacher’s retirement fund, and some in annuities (b/c my parents had scared me away from things like mutual funds). Thank God DH started investing in mutual funds in his early 20s (we didn’t meet until our mid-30s)!
“The miracle of compound interest is the secret to getting rich slowly”
Actually it isn’t. Almost no one gets wealthy by saving money in interest bearing accounts or buying interest bearing bonds. They invest their money in the stock market. And stocks don’t pay interest. Some pay dividends, but that isn’t the same as interest.
The only advantage of investing in stocks now, rather than later, is if the stocks are at a lower price now. If you buy 100 shares of stock ten years from now you might pay twice as much for those 100 shares. But from that point forward you will make the same amount either way. The cost of waiting is in the initial price you pay.
Since the cost is in the initial price, the real issue is is the opportunity cost from buying stock now. How could you have spent that money if you hadn’t bought that stock? And what is the opportunity cost of spending twice as much for that same stock a decade later? For many people, their opportunities when they are younger are much greater and their income is much lower. That means the value of opportunities lost by spending $100 at 25 are much higher than the value of spending $200 a decade later.
BTW – millionaires aren’t rich and the”millionaire next door” is pretty common. At the recommended 4% annual withdrawal that is $40,000 per year to spend for the rest of your life. A comfortable retirement for a normal middle class person, but hardly rich.
The problem is that the finance industry has successfully oversold the benefits of saving early for retirement and undersold the costs. Young people who invest wisely in themselves now, rather than in their imagined retirement, will likely have richer lives now and when they retire.
Inspirational post. I like to invest in Sharia Compliant Funds which offer great compound profits. At the moment I’m paying off all my debt and mortgage and also putting a small amount aside for retirement. At first I use to think the small amount was not really worth it but it is already starting to make a big difference.
It is possible to get rich by investing in bonds. By investing in municipal bonds, you may pay not taxes on the interest. If you purchase individual bonds, you have no transactions fees once they are purchased. You receive a predictable stream of interest that you reinvest if you want growth. You get your principal back at the due date of the investment. Wishful thinking is not a strategy.
No one knows how stocks will perform tomorrow, much less years from now. Our lives are finite and we may not be able to wait for the stock market to recover from its losses. If the losses occur just as you are retiring that can have long term negative effects on your retirement planning.
A good strategy when receiving financial advice is to ask the advisor if they are financially independent. If they say no then you might look for another advisor.
It is “possible” to get rich buying lottery tickets. But the only way to get rich investing in bonds is to buy high risk bonds that pay high interest rates and get lucky. Safe bonds don’t pay enough interest to do much more than keep up with inflation.
Bonds price is generally less volatile than stock, so they have less immediate risk when sold. This makes them an important part of an investment portfolio that is being drawn down. But a portfolio of only bonds will require that you save LOT more money to achieve the same result. That means giving up a LOT of things that you otherwise could afford.
It is true that winning the lottery will make you rich, but it will not keep you rich. In fact, most people who win the lottery loose the money because they do not understand how to deal with it. Same with placing big bets in the stock market, unconstrained markets and global markets.
It is not that you cannot make money there, it is that if you do not understand the game in the casino of hope and fear you will ultimately lose.
From my perspective it is better not to lose, and pay fees and taxes. Interest from high quality bonds is predictable, dependable and consistent. Your principal is returned. It can be scaled to your life and needs.
I’m sorry but I strongly disagree.
First you’re forgetting inflation.
And secondly ‘The only way to attain the wealth you desire is to spend less than you earn and to save the difference. The rich are not rich because they earn a lot of money; the rich are rich because they saved a lot of money.’ I disagree.
It’s completely the opposite.
The only way you get rich is to create value, a business,something a lot of people need and will pay for me. That’s what all millionaires/billionaires have in common. And most of them didn’t wait decades,a lot of them are young.
Like this website for example.
It’s helpful.
Say,30 year old puts away 2000 dollars a month at 6% interest rate ….it will take him 30 years to make a million which probably won’t be worth much. And would it really be worth it when all his life he didn’t enjoy it and just saved,saved,saved.
Also I don’t think there are any interest rates more than 6 percent.
*sorry my english is bad,still learning.
I recommend reading ”Rich dad,Poor Dad” if you haven’t already.
I totally agree with Natalie that starting a business can be very satisfying and possibly lucrative. This does not negate the need for savings in bonds. It just adds to the need because the interest from the bonds and the return of capital from a laddered bond portfolio can create a stable foundation and cushion for the unexpected events that always happen.
I don’t see the dichotomy between saving and having current life. Saving, even if it is only a dollar a week, is a discipline that once started can be built upon. There are always ways to spend money.
I live in the UK and was wondering what the UK equivalent of a dollar cost average Equity 500 index low fee managed fund would be? It all seems so confusing and at 44 years old I feel that I have left it too late to invest £50 a month.
extraordinary post.