Most individuals do not begin to think about accumulating, or are unable to set aside, funds for retirement until they reach their late 40s or 50s. Starting much sooner can be astonishingly rewarding.
In the instances of an IRA, which has a $2,000 limit on annual contributions, the annual earnings an account receiving $2,000 annually eventually will become larger than $2,000. Once that happens, the account of someone who starts contributing early enough will always be larger than that of someone who waits until middle age to start saving for retirement. This will be so even if the “early bird” discontinues contributions completely.
Compounding over long periods is what gives systematic savings plans their greatest potential. Consider, for example, an individual who contributes $2,000 per year to an IRA beginning at age 21. If the contributions continue at that rate and the account consistently earns 11.3% (which is slightly less than the total return on the S&P 500 index since 1926 as calculated by Ibbotson Associates, Inc.), the account’s value will reach roughly $3 million when the individual turns 65. The most mind-boggling aspect of this astonishing number is that half of the $3 million would reflect the compounded earnings on just the first 6 annual $2,000 contributions (totaling $12,000). The other $1.5 million would reflect the compounded earnings on the 39 annual contributions (totaling $78,000) made between ages 27 and 65. The foregoing calculation assumes away several uncertainties (such as earning a consistent 11.3% return — by no means assured over periods as short as 6 years, or even over the next 45 years), but it does indicate the extraordinary advantage of “starting early.”
However, it usually is very difficult for 21-year-olds to set aside funds in this manner (it often is difficult for 45-year-olds). This suggests an important opportunity and consideration for those who are making annual gifts (for estate planning purposes or other reasons) to children, grandchildren, and other potential heirs. Such donors might suggest, or even insist as a condition of their gift, that the recipients place as much as possible in tax-deferred pension accounts.
To be eligible to contribute to an IRA, the recipient of the gift must have earned income at least equal to the IRA contribution (up to the $2,000 maximum). If the recipient’s current taxable income and marginal tax rate is low, a Roth IRA (for which there is no current deduction for the contribution, but no tax due on eventual withdrawals) would appear to be more attractive than a regular IRA.
Finally, it cannot be stressed too strongly that only relatively secure income-producing investments should be placed in tax-deferred pension accounts (i.e., one should resist the temptation to use such accounts for “flyers” on high risk investments, in hopes of realizing large untaxed capital gains). It is the ability to compound free of taxes the income earned within such accounts that gives them their potential and power over the long term. If the value of the holdings decrease to zero, no amount of compounding will make them grow.
Also in This Issue:
The Joy of Giving
Has the Inventory Cycle Been Repealed?
Alternative High-Yield Dow Investment Strategy
The Dow Jones Industrials Ranked by Yield
Recent Market Statistics
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