With compounding interest, you can build your savings faster—and save even more.
In olden days, people stashed away extra money in their mattresses or cookie jars which is not a good idea if you have a flood or fire or even a lapse in memory. Fortunately, you now have many choices for storing your money—in reliable retirement accounts. These choices not only provide stability and security, but also give the important bonus of earning interest and compounding the value of your money, which means increasing the value of your retirement savings well beyond the amount you have deposited.
How Compound Interest Works
When you have money in an account with compound interest, it allows you to build upon your savings quickly because you earn interest not only on the amount you have contributed, but also on the interest you have earned in prior periods. Within each period you’re earning interest on the total balance in your account, not just on what you have managed to save. With this in mind, saving early is critical to meeting your retirement goals. Saving early can also reduce the need for you to contribute large sums to your savings as you near retirement.
As an example, if you put $1,000 into an account with simple interest of 2.34% Annual Percentage Yield (APY), you will have $1,702 after 30 years. If, however, you have that same $1,000 in an account with compound interest of 2.34% APY, you will have $2,018 after 30 years.
Now let’s talk about how to save for retirement.
Choices For Retirement Accounts
Once you start saving for retirement, you have several choices of retirement accounts: 401(k), Roth IRAs or Traditional IRAs.
- 401(k). Many companies now offer 401(k) savings opportunities for employees rather than pensions. With a 401(k) you have money withheld from your paycheck for a retirement account managed by the company’s financial partner. Often your contributions are withheld pre-tax, lowering the amount of taxable income in your paycheck and maximizing the amount you contribute to your retirement account. Also, it is common for companies to match a percentage of your total contribution.
- Roth vs. Traditional IRA. The Traditional IRA is funded with pre-tax funds, meaning that you don’t pay tax on the money that you put into this account now, but you will pay tax on it when you withdraw the funds from your account later on. The Roth IRA is taxed up-front, so you don’t get a tax savings on your deposit now but you won’t pay taxes on qualified distributions in retirement. Check with your financial or tax advisor for help making the best choice for your personal needs.
Whichever path you choose, try to set up regular salary contributions with a fixed amount from every paycheck going into your retirement account. The IRS has a limit on annual contributions based on age and marital status, so check to see what applies to your personal and family situation to avoid overestimating the amount you can contribute.
IRA Interest Rates/APY
Because retirement accounts are established to meet long-term savings goals, banks and other financial institutions typically consider retirement accounts to be less risky than other consumer deposit account types, such as savings and money market accounts. What that means for you is that banks may offer slightly higher IRA interest rates than regular savings accounts rates. This is another way that retirement accounts make your savings grow faster.
Any financial institution will give you current information on IRA interest rates or APY. They can’t predict the future, but with a fixed-rate IRA CD, you know exactly what interest rate your money will earn over the term you select. Like other consumer savings accounts, IRA deposits are protected by FDIC insurance, to the maximum allowed by law, making them far more secure than the money in your mattress.
The article and information provided herein are for informational purposes only and are not intended as a substitute for professional advice. Please consult your tax advisor with respect to information contained in this article and how it relates to you.