Albert Einstein once marveled at the power of compounding returns, even calling them the “eighth wonder of the world.” Think of compounding returns like a snowball rolling down a hill. As it gathers speed and momentum, it gets larger with each rotation. This analogy can be very useful, especially when saving for retirement. Over time, this snowball effect can turn your initial savings into a much larger sum.
It’s a simple yet powerful way to grow the assets in your retirement plan. So, it goes without saying that the sooner you begin saving for your retirement, the more time you have to compound your rates of return.
In this guide, we’ll break down how compounding rates of return work and show you how it can transform your retirement savings strategy.
Listen to our podcast episode, “Traditional or Roth IRA: Which is Right for You?”
How Can Compounding Rates of Return Benefit Me?
Several factors can affect the amount of compounding you earn, including capital gains, dividends, and interest, the number of years of compounding, and the length of time until you need the assets or income from the investments.
The higher the rate of return, the faster your investment will grow. Similarly, the more years your investments have to produce compound returns, the greater the amount when you retire.
For example, Let’s say you start with $100,000 and earn an annual 10% rate of return ($10,000). Now you have $110,000 and earn another 10% return ($11,000). In another year, you’ll have $121,000, and so on.
You can see how this compound effect will benefit you over longer periods. So, the sooner you start saving and investing, the more time you have to compound your returns.
Regular contributions to your retirement plan and compounding rates of return can substantially increase your retirement balances. Additionally, different types of investments offer varying returns, so choosing the right mix (stocks, bonds, cash equivalents) can impact the growth of your retirement funds.
Here’s another example of how compounding can work for you:
Let’s say you have an initial investment of $250,000, earning an annual return of 7%. After ten years, assuming there are no withdrawals, the investment value would be approximately $491,788, which means that you are close to doubling your money every ten years.
The Impact of Inflation on Compound Rates of Return
While compound rates of return can significantly grow your retirement savings, it’s equally important to understand the impact of inflation on your retirement assets.
Because inflation erodes the purchasing power of your money, if your retirement savings are growing at a rate similar to inflation, the real value of your savings is greatly diminished. This means that, over time, your ideal rate of return will have to exceed the inflation rate. This is one of the primary reasons why people like you take some risk when they invest their retirement assets.
Typically, higher inflation rates are a two-edged sword. On the one hand, rising prices hurt companies’ earnings. At the same time, the Federal Reserve raises interest rates and borrowing costs to fight inflation. As interest rates go up, the prices of existing bonds decline.
Retaining all of your retirement savings in bonds could mean higher nominal rates of return. As either a future retiree or if you’re already retired, the real return (interest rate minus inflation rate) matters for your long-term investment strategies. The key is ensuring that the return rate on your investments outpaces inflation.
Here’s an example to illustrate this:
Suppose you have a retirement account with $100,000, earning a compound interest of 5% annually. Without considering inflation, after 20 years, your account would grow to about $265,330.
Now, assume an annual inflation rate of 3%. This inflation rate diminishes the purchasing power of your assets. While your account’s nominal value will still reach $265,330 in 20 years, its purchasing power is reduced by the annual inflation rate. To find the real value of your savings that will fund your cost of living, you must adjust the future value for inflation. After 20 years, the real value of your savings would be considerably less than $265,330. Assuming a 3% annual inflation rate in today’s dollars, it could be around $155,797.
This shows that while your savings will grow due to the compounding of returns, inflation will erode some of the real purchasing power of your savings. This effect becomes more pronounced over long periods, like the span of your retirement years.
The Importance of Maximizing Your Retirement Contributions
One of the easiest ways to implement the power of compound returns is to maximize contributions to your retirement plan accounts such as 401(k)s and traditional IRAs.
In 2024, for example, you can contribute up to $23,500 into a 401(k). If you’re 50 or older, you can add $7,500 as a catch-up contribution. That’s $30,500 you can add to your retirement savings that can benefit from compounding in future years.
Your contributions also reduce your taxable income, so it’s a win-win.
About Bulman Wealth Group
At Bulman Wealth Group, our focus is helping you experience the retirement you’ve always dreamed of. To do that, we target five key areas you should think about when planning for retirement:
- Your investments
- Your retirement income
- Your taxes
- Your healthcare costs
- Your legacy
We believe that by giving these areas the attention they deserve, you’re setting yourself up for a more comfortable and fulfilling retirement. Let’s break it down a bit:
- It’s not just about where you put your money but how it works as you get closer to retirement.
- Determining how to maximize your retirement income when you stop working is a key driver for a comfortable, secure retirement.
- No one likes surprises, especially from the tax collector. That’s why we place special emphasis on tax planning now to reduce tax payments during retirement years. As we get older, this becomes a bigger piece of the puzzle. It’s smart to plan for it now.
- Finally, think about what you leave behind – it’s about more than just money; it’s about the mark you leave on the world.
At Bulman Wealth Group, we guide you through all these aspects, ensuring your retirement is as rewarding as you hope it will be. Let’s make it happen together!
