| 07 February 2005
Saving and investing at an early age is the surest way to accumulate wealth and have more lifestyle choices later in life. My clients are more educated than most people when it comes to personal finance and investing and have already embraced this concept for themselves. But we can do a great service to our children and grandchildren by passing this knowledge on to them as well.
The greatest asset a young person has is time. Time allows you to take full advantage of the “magic of compounding”. Compounding is earning interest on interest. Albert Einstein is purported to have called compounding the greatest mathematical discovery of mankind!
When money is invested the gains can be reinvested and earn interest as well as the original capital – creating an effect like a snow ball rolling down hill. The longer it rolls the larger it becomes. Consider that $10,000 invested at 10% for 10 years would accumulate to about $26,000, a very healthy gain. But if the same $10,000 was allowed to invest for 40 years at the same rate, it would grow to over $450,000 or 17 times larger!
Saving money by itself is not enough, though – you need to also invest properly to take full advantage of the long-term potential. Assume you invested the same $10,000 in a “safe” investment that only averages 5% for 40 years. Your original investment would grow to only $70,000 compared to $450,000. By doubling the rate of return you accumulate more than 6 times the wealth!
This also reaffirms that growth investments, while risky over the short run, are not risky from a long term perspective. Conversely, so-called safe investments are actually quite risky if they do not allow you to achieve your lifestyle goals.
To further illustrate the value of starting early; let’s look at the case of twin sisters Mary-Kate and Ashley who are currently age 20. Suppose Mary-Kate waits until age 30 and then starts contributing $3,000 into a Roth IRA every year until age 67 (full social security benefit age). At an average rate of return of 10% (long-term stock market average), her retirement account would accumulate to over $1 million (tax-free) by age 67!
Ashley takes a different approach. She starts contributing immediately at age 20, and puts $3,000 into a Roth IRA every year for the next 10 years but makes no further contributions after age 29. Earning the same rate of return, she would accumulate about $1.8 million! Although her sister contributed more than 37 years longer (and nearly five times as much), Ashley would have about $800,000 more in her retirement nest egg than her sister. And if she didn’t stop adding to the account, but matched her sister until age 67, she would have almost $3 million at retirement.
The moral of the story is clear. Starting to save and invest at an early age can provide financial freedom some day – and the earlier that you start the better.
Many people don’t realize that a youngster can open a Roth IRA if they have earned income even if it’s just babysitting or paper route money. And the first full time job for a young adult fresh out of school almost certainly would qualify them for the Roth IRA tax free investment account. Of course, it’s not easy to get a teenager or twenty-something to think that far ahead or to delay gratification by investing their hard earned money. There are always strong competing demands for these precious dollars.
One strategy to accomplish both objectives would be to gift to the child the equivalent amount that they earned (up to a maximum of $4,000) for contribution into a Roth IRA. This way, the child gets full current use of the money they earned yet they also get to experience the rewards of long-term investing.
You can help the young person that you care about enjoy the magic of compounding by getting them started with investing. They will thank you for it someday.
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