Compound interest can be your plan’s biggest booster.
Building a decent retirement savings can seem like a daunting task when you first set out. The numbers for how much you should sock away for a comfortable retirement can seem large. But a prudent investment plan like a 403(b) has one easily overlooked secret weapon that can turn just a little into quite a lot after only a few years. That’s compound interest.
By tending to your plan just as diligently as a gardener tending a garden, you can reap surprising benefits. A decent understanding of compound interest is one of the most powerful tools at your disposal.
Fertilizer for Your 403(b)
Let’s start with basic principles. A 403(b) is a retirement account similar to a 401(k), but available only to employees of tax-exempt organizations. Teachers, librarians, and school administrators might have a 403(b) plan, and so might doctors, nurses, ministers, and government employees. They’re usually fed by a regular payroll deduction, which makes saving something for retirement something that happens automatically. In many cases, a 403(b) account also grows thanks to matching funds from your employer – that’s free money, beyond your normal salary. The money that goes in doesn’t count as part of your income for that year’s taxes, so the more you contribute, the lower your tax bracket will be.
You can only contribute so much per year (in 2022, the cap was $20,500) and if you take any money out before you reach the ripe old age of 59 and ½, you’ll get hit with a fairly serious penalty unless you meet some narrow criteria (like separating from an employer when you’re older than 55 or needing to pay certain kinds of medical expenses). And depending on the kind of 403(b) – whether it’s a traditional 403(b) or a Roth 403(b) – you might have to pay some taxes on the money once it’s withdrawn.
The most important thing is that money in your 403(b) plan is meant to grow on its own. You can allocate your funds to different kinds of investments within your plan to try to get the best yield, just like a gardener choosing to plant tomatoes one season and cauliflower the next. A good advisor can help you get the most out of each deposit by assisting with selecting and holding investments from, for instance, several related mutual funds in one account, or the fixed and variable annuity options your account offers.
But by design, the mechanism of compound interest should always be working in your favor, snowballing slowly but surely.
Simple interest is what happens when you have a certain sum and then earn a certain percentage of that sum. On a savings account with simple interest, if you deposit $500 and earn 5% simple interest every year, you’ll get an annual payment of $25, which won’t ever change. It’s calculated from the original deposit.
Compound interest, on the other hand, is what happens when you have a certain sum, and every time you earn a certain percentage it gets added back to that original sum. For that same savings account with 5% compound interest, you’ll earn $25 your first year, but then $26.25 (5% of $525) the next year, and 5% of $551.25 the year after, and 5% of $578.81 the year after that. In other words, your garden is growing – slowly at first, but as each number gets bigger, the next number gets even bigger. Your interest is earning interest. That means that slow growth gradually gets faster, until the amount you’re putting away every interest period is far more than your initial investment and grows ever more steeply over time.
Anyone who has had to pay off a deferred student loan or overdue credit-card bill has already experienced the power of compound interest and seen just how quickly little bills can grow into major threats. But once you’ve got that mathematical fact working on your behalf, you can see how quickly small deposits can reap sizable rewards.
To get the most out of the power of compound interest, a wise investor will take a good look at a few factors: what the percentage rate is, what the starting balance will be, how often the interest accrues, and how much time you’re allowing the account to grow. Any one of those can have an outsized effect; for example, a daily compounding period will obviously grow your plan much faster than a monthly, quarterly, or yearly period. A good advisor can help you fine-tune those factors with your available resources, finding opportunities to grow your funds that you might otherwise miss.
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