We’re all well aware that we should save money for retirement, but many of us don’t know what to do or how it works. Don’t worry, you aren’t alone! This simple guide will help you understand the power of compound interest and how you can get started using it to your advantage today!
What is compound interest?
Compound interest occurs when the interest that accrues to an amount of money in turn accrues interest itself. Say a person opens a retirement account when they are 25 and saves $5,000 a year. Without compound interest, they will save $200,000 by the time they’re 65. With a compound interest rate at about 6% or higher, they’ll be a millionaire by the time they’re 65. That’s the power of compound interest!
How does it work?
All the glory of compound interest takes place in a retirement account, most commonly a 401(k) or an individual retirement account (IRA). Each type of retirement account comes with an interest rate (the average being between 8-10%) so you can calculate how much money will accumulate by the time you retire based on your age and annual savings. The most important factor to leveraging the power of compound interest is to begin as early as possible. It’s never too late to start, but the rate of return is the highest if you begin a retirement savings account in your 20’s. The longer you wait to start saving, the less time you have to accrue interest and build your savings. For the visual people out there, check out these charts that illustrate how your age affects your saving potential.
How do I get started?
All you have to do is open up a retirement account and start adding to your savings annually! You’ll need to start by choosing which type of account to open:
401(k): For most people, the best place to start is with the 401(k) program at work. This is a particularly enticing option if your employer matches a portion of your contribution (free money!). This is the easiest and most common way to begin saving for retirement, and all you have to do is sign up! Your employer does the rest and simply transfers money from your paycheck to your 401(k) account each pay period.
IRA’s: If you are self-employed or your employer doesn’t offer a 401(k) program, then you’ll have to open up an individual retirement account. IRA’s are a little more complicated than 401(k) programs since you have to choose which plan is right for you and do a little more legwork, but they often come with better tax savings and give you the power to shop for the best interest rate. There are different types of IRA’s (traditional and Roth for individuals, SEP and Simple for small business owners). You’ll need to decide which type of IRA is the right fit for you before you can start shopping for an account provider.
In summary, compound interest is simple, but important. Start saving as early as possible to see maximum benefits.
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