Tuesday, June 19, 2012

Compounding Interest

Looking back to when I was a private, there were several retiring First Sergeants and Sergeants Major who were trying to instill their parting wisdom upon the minds of those who will replace them.  One message they all shared was to save, and start now.  Not being to financially savvy, they talked about starting a Thrift Savings Plan (TSP) as it was a new program Soldiers were allowed to participate in.  As these senior Soldiers were looking toward retirement, they did not want their subordinates to make the same mistake of not taking advantage of compounding interest.

Interest is the profit you can make from investing your money.  Let’s do some simple math to see how this works.  Suppose you have $10,000 to invest and place it into a program yielding 10% interest.  After 1 year you will have made $1,000 in interest, and have a total of $11,000.

$10,000 x %10 = $1,000

So how does compounding interest differ?  Well you aren’t going to stop investing after that one year.  Now on year two we still have our original $10,000 and our earned $1,000, all of which is earning 10%.  Again our $10,000 will bring in another $1,000, and the previous earned $1,000 will bring in $100 for a total account value of $12,100. 

$10,000 x %10 = $1,000
$1,000 x %10 = $100
$10,000 + $1,000 + $1,000 + $100 = $12,100

Why should you start saving now? The longer your money has a chance to grow the more it will work for you.  Let’s imagine you have just completed basic training and there are twenty years ahead of you until you are able to retire from the military.  In our scenario you will be placing $400 a month into a Roth IRA account from now until you retire.  Doing simple math, $400 x 240 months will mean there is $96,000 in your investment account.  But what would all of that money do if it was compounding interest for you?  I am now going to adjust the scenario to earn an average of %10 a year.  After doing some computations, your account would have the $96,000 you contributed plus an additional $207,747 in interest for a total of $303,747. 

But what about your senior leader who is getting ready to retire and has only five years left in the military?  Running those numbers of $400 x 60 months you would only have $24,000 in contributions.  After letting this money compound for the 5 years, the total account value would be $30,974.  That means less than $7,000 interest earned.  Looking at these numbers, you can see why your senior leaders wish they could go back in time to when they were a private and begin saving then.

Earlier I mentioned in our scenario we would be placing this money into a Roth IRA account.  Just because your service in the military has ended doesn’t mean you can start taking deductions from your IRA. Suppose you enlisted into the military at 18 and served 20 years, you would still have another 21.5 years until you are eligible to use money from your IRA.  What would your $303,747 be at that time without any additional contributions?  Using the same interest rate as above, your account would value $2,280,750!  Wow, who would have thought being a Soldier would make you a multimillionaire? Best of all since you were placing these funds into a Roth IRA account it’s also tax free.

Please consult with your accountant for your unique situations.

A Beginner's Guide to Investing: How to Grow Your Money the Smart and Easy Way - Amazon.com

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