There are two great secrets you need to know to conquer your financial future—time and compound interest. That’s it. No smoke, no mirrors, no magic—the easy mathematical formula for making your money grow and grow is to invest your money, earn a return on it, invest some more, and earn a return on that, year after year, decade after decade.
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This is how it works: if you save and invest $5,500 a year, earn 7% a year (long-term market averages are around 9-10%) for the next 40 years, you will reach $1.2 million. Leave it in, keep investing, and in three more years you will have almost $1.5 million.
Here is the expanded version: if you invest $5,500 at age 23, earn 7% on your investment, $385, you will have $5,885 at the end of Year 1. Leave this invested, add another $5,500, keep this $11,385 invested, earn 7% on this amount, which is $797, and you will have $12,182 at the end of Year 2. Continue this “save, invest, earn” pattern for another 38 years and you will end up with almost $1.2 million at the end of Year 40.
And fortunately, if you have nothing but time ahead of you, you have the greatest financial advantage over everybody who is older than you are—the time to put the concept of compound interest to work. No wonder Einstein called compounding “the eighth wonder of the world.”
Some government designated retirement accounts such as a Roth IRA allow an investment of $6,000 a year starting in 2019 (for younger people) to grow tax-free every year. After age 59 ½, all withdrawals are also tax-free.
The big payoff comes when you can finally harvest your gains. If you have accumulated $1.2 million and continue to earn 7% a year, you can actually withdraw $82,000 a year (tax-free) without disturbing your principal. It’s like having your own money tree that grows new $100 bills every year. Just go out and pick ‘em. At this point, you have actually achieved the ultimate financial success–your money goes off to work for you everyday instead of your working for your money.
Can’t spare $5,500 to invest each year? At least start somewhere. $2,000 a year, for 40 years, at 7%, yields $427,000. This sure beats the average of only $20,000 that most people in America have saved for retirement.
For those who want to be overachievers, invest more, earn a higher rate of return, or invest for a longer time. Or do all three. (Be aware of tax consequences on yearly amounts invested over $6,000 or those not invested in government retirement accounts.) The “I Want to Be a Millionaire” app is great for plugging in your ideas and getting instant answers.
You don’t really want to wait to start investing because you may have a lot of catching up to do. Start at age 30, and you will have to invest more than $10,000 a year to reach the same goal. Invest at age 45, and you will have to invest at least $44,000 a year to reach the same goal. (And remember, that in most cases, only $6,000 a year is eligible for favorable “IRA retirement” treatment.) You also may not have the “long-term” advantage of a higher percentage return in the market if you wait.