Somehow, I have friends whose kids are about to graduate from college this year (time goes by way too fast!). I started to think, what would I want my kids to know about after graduation?
The “fun Dad” in me thought about visiting far-off lands and enjoying life.
But the “math Dad” in me thought of something more practical — the magic of compounding interest. (Sorry kids.)
Retirement – The Bleak Outlook
A theme among pre-retirees that is becoming more and more common is the lack of retirement savings. The average 50 year old has approximately $44,000 saved for retirement. This means they will be spending the next 15 years or so frantically saving for their golden years. This is in addition to helping kids with college expenses, home repairs, and hopefully enjoying a little bit of travel.
Unfortunately, most people don’t have the luxury of doing all the above. However, if we can get our kids to start saving early, we can help them avoid a pre-retirement scramble.
source: Source: U.S. Census Bureau, Statistic Brain
Compounding Interest: What it is, how it works
For my fellow math geeks:
P = principal amount (the initial amount you deposit)
r = annual rate of interest (as a decimal)
t = number of years the amount is deposited or borrowed for
A = amount of money accumulated after n years, including interest
n = number of times the interest is compounded per year
In layman’s terms:
Compounding interest can be thought of as “interest on top of interest”. This interest on top of interest allows a higher growth rate than interest with no compounding:
Compound interest can significantly boost investment returns over the long term. While a $100,000 deposit that receives 5% simple interest would earn $50,000 in interest over 10 years, compound interest of 5% on $10,000 would amount to $62,889.46 over the same period.
While the magic of compounding has led to the apocryphal story of Albert Einstein supposedly calling it the “eighth wonder of the world and/or man’s greatest invention”, compounding can also work against consumers who have loans that carry very high interest rates, such as credit card debt. A credit card balance of $20,000 carried at an interest rate of 20% (compounded monthly) would result in total compound interest of $4,388 over one year, or about $365 per month.
Compounding Interest in Action – aka How To Turn Your Kid Into A Millionaire
To give an example of how powerful compounding interest can be, let’s assume we are able to help or encourage our child to contribute $2000 per year into a tax-free vehicle, like an IRA, from age 19 to 26. At retirement, our child would be better off than the person who contributed the same yearly amount from ages 27 to 65:
(This is assuming a 12% average annual rate of return — which is an entirely different article that will be addressed at another time.)
This concept can greatly impact the quality of their future life. However, most people are not exposed to the concept of compounding interest until they are much older and begin researching retirement investments on their own.
In fact, one quarter of 25-32 year olds have less than $5,000 saved:
Resources To Help
We help them choose colleges, majors, wedding locations, maybe even baby names. But not many parents take the time to explain what benefits their kids should be choosing on their first day of work.
Some resources to help them out:
AARP has a nice calculator to help illustrate how much they will need to save: AARP Retirement Calculator
Wall Street Journal: What is a 401(K)
Employer matching and vesting: Matching Contributions From Your Employer Can Help Build Your Retirement Account (Nationwide)
If you want to start them early: The Benefits Of Starting An IRA For Your Child (Forbes)
Lastly, make sure they understand tax free growth:
Last thought of the day: I have seen young clients walk into my office with very large 401k balances. Not one has ever told me they got to that point because they picked the next Apple, Google, or (insert hot stock of the day). The answer is always the same: I started putting money in my 401k the first chance I had.
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