Compounding Growth — Earning earnings on earnings on earnings
As the investments in your retirement account appreciate, or increase in value, your money grows. Part of that growth may come from the earnings or interest on the securities you hold in your account. Those earnings are reinvested and you can continue to generate more earnings on the original amount invested, plus the earnings. That’s the power of compounding.
Compounding at its simplest is earning interest on interest.
Time is on your side
What makes compounding powerful is that its effects are magnified over time—provided your investments generate positive returns over time—because earnings are able to build on previous earnings. So if you can invest for retirement over 30 years instead of 20 years, you have the potential to make more money because your account can compound for another 10 years. This may work particularly well in a tax-deferred retirement account like an Individual Retirement Account (IRA) or a 401(k) plan, because your earnings are not being reduced by taxes. So 100 percent is reinvested.1
For example, let’s say you save $250 a month in your 401(k) plan and your investments earn an average 6% annual return. After 20 years, your account balance would grow to $115,510. But after 30 years—just 10 years longer—your account would more than double, coming in at $251,129.
Of course, you’re adding $250 a month in savings contributions over those additional 10 years, and that helps the account grow. But even if you stopped contributing after 20 years and just let your account balance compound at 6% annually, at the 30-year mark, your balance would be $210,159. That’s an additional $94,649 all from another 10 years of compounding growth.2
Put the power of compounding to work
To get the most out of compounding’s potential in a retirement account, you need to do three things:
- Save consistently — Contributing money steadily, year after year, helps your account grow.
- Start early — The more years you can save and invest, the more compounding can do its thing.
- Generate earnings — You have a little less control over this one, because investments can fluctuate in value (and even lose value), but if you manage your investments carefully, any positive returns will get reinvested and compounding will go to work for you.
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1 Withdrawals are subject to income tax and withdrawals prior to age 59 ½ may be subject to a 10% tax penalty.
2 For illustrative purposes only. Your investment returns may be higher or lower. This is not meant to predict the returns of any particular investments over time. Earnings are not guaranteed. Any investment has the potential to lose money.