Tuesday, August 3, 2010

16) Seven and a Half Sense Doesn’t Buy a Helleva Lot - or Does It?

his isn’t the Pajama Game; but it’s close.  This is the power of compounding.

            It’s a force of financial nature.  Even an extra 3% can add up over a long period.  Every little bit helps.  It adds up faster and bigger than most expect. 

            Benjamin Franklin didn’t say ’a penny saved is a penny earned’; he stated, ‘a penny saved is tuppence’’ - two pennies.  The one you earned can be invested to you earn you more.  Capitalism, friends, Capitalism.

            If you invest only $2,000 a year over 40 years of work (e.g. ages 27 - 67), you’ll have contributed $80,000.  At 2%, that would grow to over $123,000.  At 5%, it would grow to over a quarter million dollars; at 8%, you’d have over half a million dollars!  Can you contribute from your tax refund or somewhere else?

            Let’s say you ‘maxed out’ your Roth IRA contribution for 40 years at $5,000 a year (it can be bigger for those over age 50); you’d contribute $200,000.  At 2%, you’d have over $300,000, at 5%, you’d have over $600,000!  What a difference 3% can make!  At 8%, you’d have almost $1,400,000.

            Instead of an IRA,, what if you add $9,000 a year to your 401(k)?  (Self-employed or not; profit or not!!)  Over 40 years, you’d contribute $360,000, and at 5% you’d have over $1,100,000.  If you get paid every two weeks and you added each time, you’d actually have an additional $8,000+ from compounding!

            If you ‘maxed out’ your 401(k) employEE portion (there could also be employer matches and profit-sharing), by contributing $16,500 per year, after 40 years, you’d have contributed $660,000.  At 5%, you’d have almost $2,100,000 but if you added biweekly, you’d have over $2,100,000.

            The more frequently you add, even in smaller amounts, the more likely you’ll be to have more money at the end of a long period of time, even when rates of return are low!

            Do you know about the twin siblings, John and Jane Public?

            Jane started to work at age 21, and immediately started to save $83 per biweekly paycheck ($2,000.yr) into her 401(k).  Many times, Jane had heard me say that everyone should save between 5% and 20% of their income out of every paycheck (not monthly, by when you may have spent it).

            It didn’t matter to her that she was entitled to the tax-deduction (and maybe the tax credit!),  However, the tax money she saved, effectively made her $83 cost here even less because of what she no longer had to pay to Uncle Sam.  She simply wanted to get started early on her retirement and felt she could afford a little now by watching her budget.

            It also didn’t matter to her, that her employer was willing to match her contributions dollar-for-dollar up to 6% of her income (which would mean she would already double her money on that first 6% before she invested it).  She knew that the maximum she could contribute was 15% of her pay, up to some maximum dollar amount, but had chosen only 5%.  (5% of her $40,000 income was $2,000.)

            She contributed every month until she was 35 years old (14 years).  At that point, other things in her life caused her to stop contributing.  She rolled over the 401(k) to a Traditional IRA and let it sit and grow until she was 67 years old.  Each and every year she earned 6%.

            Jane’s brother, John Q., didn’t start to save at age 21.  He had different goals, interests and values.  He started saving at age 30.  He contributed to a 401(k) out of every biweekly paycheck ($2,000/yr) until he was 67 years old.  John also earned 6% on his 401(k) every year for those 37 years.

            Guess who had more money.  Yup, Jane.  Jane has $298,850; John has $273,399.  A smart money decision.

            Compounding; you gotta love it.  Tuppence, Baby; tuppence.  Call me.

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