The Magical World of Tax Deferred Compounding Interest

 In Mountain Money Monitor

Each year I teach a basic money-saving and investing course for the seniors at Incline High School. I really enjoy interacting with our future. However, each and every year I am amazed by the absolute lack of financial knowledge most of these 18-year olds possess! This is particularly troubling because financial trouble in the form of credit card debt is just waiting to pounce on these young men and women. But this article is not about debt. Most debt is evil and everyone knows it, but the great majority of Americans have too much of it. Rather, this article is about the power of compounding interest and its effect on your future.

I start off every class by asking the seniors how many of them have held a real job. As you would assume, most of them have had a job. Then I ask them how many of them contributed to an IRA account since they generated taxable income from their job. I believe that out of all of those working 18-year olds who I have taught this class to, I have seen TWO hands go up. Most of them look at me like I’m crazy because they are dreaming of the day they can legally buy beer, not the day they retire.

That is when I introduce the concept of interest and the magical world of compounding interest. In a nutshell, when it comes to building wealth, time is your most powerful ally. Thanks to some data crunched by PricewaterhouseCoopers, I am able to show them the power of time and the magic of compounding interest. I give the students two scenarios: The first is a person who diligently saves $1,300 per year for 42 years. The second person fails to save for the first 21 years and then tries to make up for it by investing twice as much ($2,600) per year for 21 years. At first glance one would assume that the make-up strategy would work. But it doesn’t! And for those students that are actually still listening to me rather than cruising on SnapChat, the results are impressive. Both people in the example saved $54,600 and they receive 5% annually on their savings. But their ending balances are vastly different. Person #1 who had saved $1,300 per year for 42 years had an ending balance of $427,158. Person #2 who partied for the first 21 years and then tried to make it up by saving $2,600 per year for 21 years only had a balance of $141,588. In this example the power of time plus the magic of compounding interest garnered Person #1 an extra $285,570.

Hopefully, a figure as large as $285,000 rekindles my students’ attention. It is at this point that I go back to my first question; how many of them who had earned taxable income had contributed to an IRA account. This is the real focus of the discussion. If you earned taxable income by working, open an IRA. And for the great majority of these young adults they qualify for a Roth IRA.

Getting started early is the greatest gift you can give yourself or your children or grandchildren. Personally, my son, who is only 16 and has no real say in the matter, has had a Roth IRA for two years now. I made sure that he contributed as much as he could even if I had to help him cover some of his expenses due to his Roth IRA contributions. The pay-off is too big to ignore. That small amount contributed today will be a welcomed surprise for my son in 2060 when he is considering retirement.

Published in the Squaw Valley Times on January 20, 2017