Retirement Planning & Compounding Interest

http://www.mindyourfinances.com/money-management/savings/081104-04

The Power of Compound Interest

How important is it to begin putting aside money for savings right now, as opposed to sometime later?

The following chart illustrates the effect of compound interest on savings over the course of 40-plus years. It shows that now is the time for saving.

The sooner you start to save, the greater the benefit of compound interest. Compound interest is the interest earned on reinvested interest, in addition to the original amount invested.

Here’s an example: Two different individuals Darryl and Cheryl, each 22 years old have an extra $2,000 a year to invest or spend as they choose. Darryl opens an Individual Retirement Account (IRA) to start saving. Cheryl chooses to spend her $2,000.

In this example, Darryl’s IRA earns 12% per year. Darryl saves $2,000 per year for six years, then never puts another cent into his IRA.

Cheryl spends her $2,000 per year for six years. After that time, she invests $2,000 per year until she is 65 years old. Cheryl earns the same 12% interest per year that Darryl does.

The chart below shows the value of Darryl’s and Cheryl’s respective IRAs, from the time they are 22 years old all the way to 65. Keep in mind, Darryl’s total investment is $12,000 ($2,000 per year for the first six years), while Cheryl’s is $74,000 ($2,000 per year for the last 37 years).
Age        Darryl        Cheryl
22         $2,240              $0
23           4,509                0
24           7,050                0
25           9,896                0
26         13,083                0
27         16,653                0
28         18,652         2,240
29         20,890         4,509
30         23,397         7,050
35        41,233        25,130
40        72,667        56,993
45      128,064      113,147
50      225,692      212,598
55      397,746      386,516
60      700,965      693,879
65   1,235,339   1,235,557

As you can see, with compound interest, the earlier you start saving, the greater the accumulated interest on your original investment. The important thing is to start saving your money. The best time to start saving is now no matter how large or small the amount. It’s never too late to start. Remember, today is the first day of the rest of your life, so get time on your side and plan for your future by starting to save now.

Deal Hunter: Retirement savings shocker

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Katherine Boyle
Deal Hunter columnist

Deal Hunter: Retirement savings shocker

By Katherine Boyle,

Want to terrify yourself, carefree 20-something? Divide 1 million by 40 — the number of years until retirement — and you’ll see a nice round 25,000. That’s how much, in dollars, you’d need to save each year if you were stuffing money under a mattress to save your $1 million retirement nest egg. Thankfully, this is not how you save for retirement.

“The calculation of ‘I need $1 million dollars by 65, so I’ll divide by 40 .?.?. is dramatically off,” said Antwone Harris, a certified financial planner with Charles Schwab in the District. “It’s not accounting for compounding interest or rates of return.”

But those compounding interest rates mean one complicated thing: You must invest your savings as soon as possible. Why? According to Ameriprise Financial, waiting even one year can have dramatic effects. If you invest $5,000 every year beginning at age 30 instead of 31, you will have $109,000 in additional savings, assuming an 8 percent compounded annual interest rate.

So how much should you invest? What will you need for retirement? And how important is it to start investing every spare penny you make in your 20s? Too many factors go into the calculation to generalize (and there’s not enough space here to explain a complex mathematical formula), so we used CNN Money and Charles Schwab Moneywise retirement calculators to get ballpark figures of what you should be saving. Read. Weep. Then invest.

If you’re 25

How much will I need to invest each year for retirement?

Low figure: It’s assumed that you’ll need 80 percent of your pre-retirement income when you retire at 65. Let’s say you make $50,000 a year. If you’re 25 and have no savings, CNN Money says you should be saving $4,550 annually, adjusted for 2.5 percent inflation. (This calculator assumes you will be receiving Social Security benefits. More good news: Some experts do not think Social Security will exist in 40 years.)

High figure: Charles Schwab MoneyWise Calculator offers a higher figure. If you’re 25 and plan to retire at 65 with 80 percent of your pre-retirement income, and expect to receive Social Security benefits, you need to save $6,900 annually.

How much will I need for retirement? CNN Money assumes you will need $1.9 million ($572,283 in today’s dollars) to retire at 65 years old, with a life expectancy of 85. Charles Schwab estimates you will need $1.8 million in future dollars.

What should I save each paycheck? If you’re paid every two weeks, you should save $175 to $275 each pay period to meet the estimated goal.

If you’re 35

How much will I need to invest each year for retirement?

Low figure: You’ll need 80 percent of your pre-retirement income when you retire at 65. You make an annual salary of $50,000. If you’re 35 with no savings, CNN Money recommends saving $6,650 annually, adjusted for 2.5 percent inflation. (This calculator assumes you will be receiving Social Security benefits.)

High figure: Charles Schwab MoneyWise Calculator says if you’re 35 and plan to retire at 65 with 80 percent of your pre-retirement income, you need to save $11,200 annually.

How much will I need for retirement: CNN Money assumes you will need $1.4 million or $577,458 in today’s dollars to retire at 65 years old. Charles Schwab estimates you will need almost $1.3 million in future dollars.

What should I save each paycheck? If you’re paid every two weeks, you should save $255 to $430 each pay period to meet the estimated goal.

If you’re 45

How much will I need to invest each year for retirement?

Low figure: You’ll need 80 percent of your pre-retirement income when you retire at 65. Let’s say your annual salary is $50,000. If you’re 45 and haven’t saved anything, shame on you. Still, CNN Money suggests you should be saving $9,850 annually, adjusted for 2.5 percent inflation. (This calculator assumes you will be receiving Social Security benefits.)

High figure: Charles Schwab MoneyWise Calculator offers a higher figure. If you’re 45 and plan to retire at 65 with 80 percent of your pre-retirement income, and are counting on Social Security, you need to save $20,300 annually. This number is very difficult to achieve on a $50,000 salary.

How much will I need for retirement: CNN Money assumes you will need a total of $1.1 million ($582,681 in today’s dollars) to retire at 65 years old. Charles Schwab estimates you will need $1 million in future dollars.

What should I save each paycheck? If you’re paid every two weeks, you should save $378 to $780 each pay period. Eek!

THE BOTTOM LINE:This is painful. Seeing these numbers might make you cry (particularly if you’re 45 or older.) The key is to start saving now. If you’re company has a 401(k) plan, enroll immediately and contribute enough to meet your company’s match. If you’re young, build an aggressive stock portfolio with the help of a financial adviser.
http://www.washingtonpost.com/lifestyle/style/deal-hunter-retirement-savings-shocker/2012/05/18/gIQAuxDAZU_story.html(external link)

http://www.msmoney.com/mm/planning/retirement/retirement_accounts.htm

Government and employer sponsored retirement accounts such as 401(k)s and IRAs are the best ways to save for your retirement goals. Depending on your situation, you can choose from:

  • For (almost) everyone: IRAs (Regular, Spousal, Roth)
  • For employees at larger organizations: 401(k), 403(b)
  • For small businesses and the self-employed: SEP IRAs, Keoghs, SIMPLEs

In this section, we describe:

  • Why retirement accounts are such powerful investment vehicles for retirement savings.
  • The primary types of retirement accounts (including 401(k)s, the various types of IRAs, and options for the self-employed).
  • Some basic strategies for deciding how to invest these funds.

Why Retirement Accounts Are So Powerful

Government and employer sponsored retirement savings accounts are the most powerful retirement vehicles available because they combine the benefits of 4 of the most effective principles of saving:

  • Compounding interest
  • Consistent saving
  • Reduction in taxable income
  • Tax-deferred growth

Compounding interest

By investing early (ages 19-26) to let the power of compounding work for her, Sue invests 1/5 as much as Kim but earns 25% more than Kim.

Compounding is a cumulative “snowball” effect of interest accumulating over time, both on your original investment as well as the interest earned. Money compounding at a steady rate of return grows not at a constant but at an accelerated rate. So the longer your money can compound, the more you will enjoy the benefits.

Without compounding, $1,000 invested at 10% for 20 years would grow to $3,000. This may sound fine, but with that same investment compounding at 10% interest, you would end up with $6,730–almost 7 times your original investment.

Consistent saving

Steady progress towards retirement savings, even if small and steady, has proven to be the most successful approach to saving for retirement.

Why?

The reason isn’t financial–people simply tend to put off saving for retirement, and thereby let valuable time pass when their money could be compounding. Compounding is just as effective on small amounts of money as it is on large amounts.

Reducing taxable income

One of the best reasons to use retirement accounts (some, but not all, offer this benefit) is that those contributions reduce your taxable income. In other words, you don’t have to pay taxes on the amount you invest.

This may not sound all that significant, but if you consider that you don’t have to pay tax on a $4,000 contribution to your retirement account and your effective tax rate is 28%, you simultaneously save $1,120 in taxes and have that much more money compounding for you.

Tax-deferred growth

Much like reducing your taxable income, tax-deferred investments are given special tax status. With retirement investments, you have to pay capital gains tax when you sell investments for more than their purchase price. You also pay tax on any dividends received. In tax-deferred retirement accounts, however, your money is allowed to grow tax-free, so you only have to pay taxes when you withdraw funds from your account. Since taxes don’t take a bite while your money grows, the acceleration of compounding is maximized.

Retirement Vehicles

Individual retirement accounts

Summary of Tax Law Changes fro 2005-2010

You may contribute up to $4,000 of your earnings for2006 or up to $5,000 if you are age 50 or more because of the extra $1000 catch-up amount. You may fund a traditional IRA, a Roth IRA (if you qualify), or both, but your total contributions cannot be more than these amounts.

You may be able to take a tax deduction for the amounts you put into a traditional IRA, depending on whether you – or your spouse, if filing jointly – are covered by an employer’s pension plan and how much total income you have. You cannot deduct Roth IRA contributions, but the earnings on a Roth IRA may be tax-free if you meet the conditions for a qualified distribution.

How do these IRAs differ? Roth and Spousal IRAs were created in 1998 to offer more flexible alternatives to the regular IRA

(check with www.irs.gov and your tax advisor for current and complete information)

Spousal IRAs

  • These allow spouses to take full advantage of IRAs, regardless of the other spouse’s retirement arrangements.
  • A full-time homemaker is now eligible for an IRA contribution of up to $4,000, even if he or she doesn’t generate income.

Roth IRAs

These IRAs were designed primarily for people with qualified company retirement plans or whose income exceeds the deductibility limits of traditional IRAs.

  • Contributions made to Roth IRAs are not tax-deductible, but when you withdraw your money in retirement, you will not have to pay taxes.
  • You can withdraw the amount invested at any time without penalty or tax.
  • The earnings, however, are subject to penalty and tax. This flexibility is very attractive to many savers.
  • Unlike traditional IRAs, Roth IRAs don’t have a mandatory withdrawal in retirement. This makes Roth IRAs attractive for passing tax-free wealth to heirs.

Which type of IRA is best for you? Learn more about IRAs and compare the options with a Regular IRA or Roth IRA Tool.

Employee retirement accounts: 401(k), 403(b)

What exactly are these? In a sense, these are personal pensions. In the past, large corporations administered defined 401(k) and 403(b) benefit plans (or in other words, pensions) that guaranteed a certain level of income after you retire. Now, 401(k) plans are becoming more common because pensions are costly to administer, and people are changing jobs more often.

Instead of defined benefits, 401(k) plans have defined contributions. Employers define how much they will contribute up front but make no promises about what you will have when you retire. You administer the funds in your 401(k) plan, and are responsible for making sure that they are invested appropriately to provide enough money for you during your retirement. 403(b) plans are similar to the 401(k)s, but are designed for public-sector employees.

Certain 401(k) plans are better than others but they are all sound retirement vehicles. Why?

  • Contributions are tax-deductible.
  • Investments grow tax-deferred.
  • The annual contribution limit is high–$14,000 for 2005 and $15,000 for 2006. Employees age 50 or over may be eligible to make an additional contribution of up to $4000 in 2005 and $5,000 for 2006.

    For further information, refer to Tax Topic 424, 401(k) plans.

  • Companies that offer 401(k) plans usually have a direct draw system so your contributions to your 401(k) are automatically withdrawn from each paycheck, so you can effortlessly and steadily save.
  • Employers make matching contributions. The typical match is between 50-100% for between 3-6% of your salary and does not apply to the employees annual contribution limit. The matching employer contribution can range from 0%-100% with a maximum of no more than 6% of the employees salary.
The best reason of all to take advantage of a 401(k) plan is the matching contributions from your employer. See this example and the tremendous savings that are created:

  • Situation: annual salary $60,000
  • 401(k) saving rate: 10% ($6,000/yr)
  • Company match: 50% ($3,000/yr)
  • Investment return rate: 8%
Number of Years Your investment Company match Account value Return on Your Investment
5 $30,000 $15,000 $57,000 90%
10 $60,000 $30,000 $141,000 135%
15 $90,000 $45,000 $263,700 193%
20 $120,000 $60,000 $444,600 271%
25 $150,000 $75,000 $710,550 373%

For Small Businesses and the Self-Employed

The retirement savings plans that big companies offer like the 401(k) are wonderful, but their complexity and cost make them inaccessible for small businesses, not to mention the self-employed.

To help both groups, the government created special retirement savings plans such as:

  • Keoghs
  • SEP IRAs
  • SIMPLEs

In essence, these retirement accounts allow you to set up a personal pension. Like IRAs, the contributions you make to these plans are tax-deductible and cannot be withdrawn before retirement age without penalty.

What distinguishes these retirement vehicles are their much higher contribution limits; depending on the type of account, you can invest between $6,000 and $30,000 per year. The drawback to these plans–at least if you have employees is that employers must contribute the same percentage of their salaries to their employee’s accounts as they do to their own accounts.

Click here to learn more about the specific qualifications and rules of each kind of retirement account.

Asset Allocation Within Your Retirement Account

Women often invest their retirement accounts too conservatively, so they yield lower returns and can be left shortchanged during retirement. Regardless of the type of retirement account you use, the principles of asset allocation remain the same and will help you achieve the right balance between risk and return.

Asset allocation may sound a little esoteric. Technically, the term means figuring out the right mix of growth investment vs fixed investments. In other words, asset allocation simply means finding the mix of investments that balance risk and return given your age, risk optimal tolerance, and investment goals.

Why Determining the Right Asset Allocation Matters

Average annual returns since the 1920s for different investments:

Small company stocks:

12.7%

Large company stocks:

11.1%

Bonds:

5.2%

Along with when you start investing, the rate of return on your investment will determine how much your retirement savings will grow. Your rate of return typically depends on the amount of risk you’re willing to take–the riskier the investment, the higher the potential return.
The value of $2,000 invested per year ($166 a month) with different rates of return

  4% 5% 6% 8% 10% 12%
10 years $24,443 $25,777 $27,204 $30,369 $34,433 $38,186
15 years 40,851 44,370 48,276 57,442 68,802 82,930
20 years 60,885 68,232 76,699 97,777 1,26,055 1,64,219
25 years 85,346 98,855 1,15,037 1,57,870 2,20,254 3,11,889

For a more detailed discussion of these investment vehicles, read MsMoney.com’s Investing section or go directly to Stocks, Bonds, and Mutual Funds.

Determining the Right Asset Allocation For Your Retirement Plan

To determine the right mix of investments, you can use MsMoney.com’s quick rule of thumb:

  • Take your age and subtract it from 110.
  • The answer is the percentage of assets you should put in stocks or stock-based mutual funds.
  • The rest of your assets should go into something less volatile such as bonds and fixed-rate securities.

Rule of Thumb: Asset Allocation for Retirement Account

Your Age 110 – Your Age % of Assets in
Growth Investments
% of Assets in
Fixed Investments
20 90 90% 10%
25 85 85% 15%
30 80 80% 20%
35 75 75% 25%
40 70 70% 30%
45 65 65% 35%
50 60 60% 40%
55 55 55% 45%
60 50 50% 50%
65 45 45% 55%

In general, the older you become, the smaller portion of your retirement account you will invest in higher risk stocks. The closer you reach your retirement age, the less risk you will want to take with your investments.

 Retirement Goals
 Retirement Accounts
 Retirement Years
 Early & Semi-Retirement

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