Your Money_ The Missing Manual - J. D. Roth [142]
After you finish paying off your debt, saving for retirement is easy: Take the amount you were putting toward debt reduction each month and—instead of spending it on Stuff—stick it in a retirement account. You've already developed the habit of using the money to improve your financial life; this is just another way to do it!
The Power of Compounding
On its surface, compounding is innocuous—even boring. How much does it matter if you start saving now? Will it truly make that much of a difference?
In the short term, compounding doesn't make a huge difference. But remember what you learned in the last chapter: Investing is all about taking the long view. Short-term results aren't as important as what will happen over 20 or 30 years.
Imagine you make a one-time, $5,000 investment when you're 20 years old. Assuming the return on that investment is 8% per year (in real life, you're never going to find an investment that guarantees this much, but bear with me), even if you never touch the investment again—never add or withdraw any money—you'll have nearly $160,000 by the time you retire at age 65. But if you wait until you're 40 to make your single investment, that $5,000 would grow to only $34,000. As you can see from this example, time is the main ingredient in compounding.
You can get even more out of compounding through systematic investing (see All-in-one funds). It's great that a single $5,000 investment can grow to $160,000 in 45 years, but it's even more exciting to see what happens when you make saving a habit. If you invest $5,000 each year for 45 years (for a total of $225,000 invested) and the money earns an 8% return every year, your savings will grow to over $2.24 million—nearly 10 times what you invested!
Note
In real life, there's no way to earn a guaranteed 8% per year. As you learned on How Much Do Stocks Actually Earn?, the stock market returns an average of 10% per year—but this average is not normal. Because stock market returns fluctuate wildly, if you invested $5,000 into a stock-market index fund every year for 45 years, you could have anywhere from less than $1 million to well over $4 million when you retired, even if your average return was exactly 8%. Confused? Just remember that, even with the power of compounding, you need to watch your progress and make course corrections along the path to retirement.
To make compounding work for you:
Start early. The sooner you start, the more time compounding has to work in your favor, and the wealthier you can become. (The next best thing to starting early is starting now.)
Stay disciplined. Make regular contributions to your savings and retirement accounts, and do what you can to increase your deposits as time goes on. (This is part of paying yourself first—see Get in the game.) Don't sabotage yourself by cashing out your retirement account when you move from one job to the next. And don't be tempted to sacrifice your future well-being for a few more bucks today.
Be patient. Don't touch the money; compounding only works if you let your investments grow. You can think of it like a snowball of money: At first your returns may seem small, but eventually they become enormous.
Tip
To learn more about compounding, check out the compound-interest calculator at Money Chimp http://tinyurl.com/MC-compound).
A Brief Guide to Retirement Accounts
A lot of people believe that wealth is something that happens all at once, through inheritance or winning the lottery or magically picking the right stock. But in reality, you get rich slowly. The road to wealth is like a marathon: It's a long race, and the best approach is measured, even paces. To help yourself win this "race," it's important to make the most of your retirement accounts.
When you put money in a regular investment account like the ones discussed in Chapter 12, you're using after-tax money: You earned the money through your job, paid tax on it, and then used it to buy stocks and bonds. And when you sell your investment, you'll have to pay taxes on the returns