To be as financially prepared for retirement as possible, it’s important to save money, but it’s more important to make sure you’re growing that money and receiving good long-term returns. Luckily, this doesn’t have to be hard. It’s very possible to 10x your retirement savings while barely lifting a finger. It’s all about time and consistency.
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Let compounding work its magic
When investing for retirement, the greatest thing on your side is time. The reason time is so important isn’t necessarily because you can save more (although that’s important); it’s because of compounding. Compounding happens when the money you make on your investments begins to make money on itself.
For example, if you invest $1,000 and earn 10%, you’ll make $100. If you reinvest the $100 and earn another 10%, you’ll now make $110. Assuming you reinvest the $110 and earn another 10%, you’ll now make $121. It’s a wealth-building cycle, but for compound earnings to really work its magic, it needs time.
To really see the power of compounding, let’s imagine you invest $10,000 right now for retirement. If you invest the $10,000 into an exchange-traded fund (ETF) like the iShares Core S&P 500 ETF (NYSEMKT: IVV) — which has historically returned around 10% annually over the long run — here’s the approximate amount you’d have accumulated at different years invested.
Years Invested
Annual Return (Including Fees)
Amount Accumulated
10
9.97%
$25,866
20
9.97%
$66,908
25
9.97%
$107,610
30
9.97%
$173,071
40
9.97%
$447,681
Data source: Author calculations.
With 10% average annual returns, a one-time investment can more than 10x in value in 25 years, thanks to compound earnings. Also, note that although it takes 25 years to go from $10,000 to over $100,000, the value increases by over $65,000 in the five years between years 25 and 30 and increases by over $274,600 in the 10 years between years 30 and 40. The more time, the larger the gap becomes.
In order to get the positive impact of compounding, you’ll typically want to reinvest any dividends your stocks pay off. Had you taken dividends as cash payouts, you would’ve made money over those spans, but it wouldn’t have been anywhere close to the difference in value you get by reinvesting them.
Ideally, you would reinvest your dividends throughout your career to let them compound and then begin receiving them as cash payouts in retirement to have supplemental income. Even a modest 2.5% dividend yield on $500,000 in investments could bring you over $1,000 monthly ($12,500 total) in retirement.
Potentially save on taxes
A Roth IRA is a retirement account that allows you to save and invest after-tax money and then receive tax-free withdrawals in retirement. Giving you a chance to have your money grow and compound tax-free is one of the best gifts Uncle Sam has provided. Most people fall into the 15% capital gains tax rate, meaning that for every $100,000 in capital gains, $15,000 is owed in taxes.
With enough time, people can easily make hundreds of thousands in capital gains, meaning they could save five to six figures by using a Roth IRA. The one drawback of a Roth IRA, however, is that it has an income limit. For 2023, the income limits for Roth IRA contributions are $153,000 for single filers and $228,000 for those married and filing jointly.
If you’re not currently, you may eventually find yourself over the income limit, so it’s always best to take advantage of a Roth IRA while you can. Even if you eventually cross the income limit, the investments you’ve already made will continue to grow and compound until you take withdrawals in retirement.
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Stefon Walters has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
