Time + compound interest = lots of wealth

By David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA Chief Actuary

Hey, parents.  Want to give your teenager a gift that may last a lifetime?  If she has a job, consider setting up a Roth IRA and making a contribution equal to the amount she earns.  With the magic of compound interest, the small amount you put aside now will grow into an eye-poppingly large number when it is time for her to draw on those funds.

Consider the following three ladies who can earn a consistent 7.00% per year in an IRA:

  • Anastasia works at the mall from age 16 through age 20. At the end of each of those five years, her parents give her $5,000 for her to contribute to her IRA. After that, she never saves another dime.
  • Isabella gets a job out of graduate school and saves $5,000 at the end of each year from age 25 through age 34 (10 years). After that, she never saves another dime.
  • Jessica gets a late start and contributes $5,000 to her IRA at the end of each year from age 35 through age 64 (30 years).

Which of these women will have the most money at age 65?  If you said Anastasia, go to the head of the class.  Her $25,000 will grow to $564,391 by 65.  Isabella will have $525,872, while Jessica will have $472,304.

What is Anastasia’s secret?  She had time on her side (as well as parents who could afford to slip her $5,000 per year).  Using the “rule of 72,” Anastasia’s money will double twice by age 40 – an age at which Jessica has just gotten started saving.  As to where the money comes from, Anastasia doesn’t need to deprive herself of spending what she’s earned.  Someone else can give her the money to put aside.  We recommend a Roth IRA in this situation.  Anastasia’s marginal tax rate is probably low, so she should go ahead and pay taxes now on the contributions rather than opening a traditional IRA and getting taxed at retirement when she’s likely in a higher tax bracket.

Most people do not have the means or the foresight to do what Anastasia and her family did.  Isabella represents a more typical situation.  She, too, is getting a relatively early start on saving and will reap the rewards down the road.

All too many workers are like Jessica, unfortunately.  For whatever reason – be it student loan debt or low starting wages or family obligations – she is not able to start saving until age 35.  As you can see, she will have a long, uphill climb as a result.  She will need to put more aside each year to get back on the same plane as her friends, Anastasia and Isabella.

As they say, it’s not about timing the market, it’s time in the market.

— Topics: Retirement