When you put money into a retirement savings plan such as an individual retirement arrangement or an employer-sponsored 401(k) plan, you want to invest the money so your account can grow. Interest earned in a retirement plan isn’t taxed during your working years, so your savings can build rapidly. If you have invested in securities that return compound interest, your savings will build even faster.
Compound interest makes your retirement fund grow faster because you are earning interest on your interest. To compound, add to your principal to the interest earned in the previous year, and use that larger principal amount as the starting point to earn interest in the current year. The formula for compounding interest calls for multiplying your principal by the sum of 1 plus the periodic interest rate expressed as a decimal, and repeating the multiplication for as many times as you have interest periods.
Compounding works even faster if interest is compounded more than once a year, a practice known as periodic compounding. A rate of 5 percent annually, compounded every 6 months, doesn’t mean you earn 5 percent every 6 months. This means you get 2.5 percent (0.025) interest every 6 months, which equals 5 percent per year. The growth rate accelerates a bit because you are adding to your interest-earning principal every 6 months instead of every 12 months. To find your periodic interest rate, you divide your annual interest rate by the number of compounding periods per year.
If you invest $1,000 at 5 percent (0.05) annual interest for 10 years, and if the interest is paid to you each year, you'll earn $500 in interest over the 10-year span. But if you annually compound your 5 percent interest by adding your interest earnings to your principal each year, you'll earn $628.90 in interest at the end of 10 years, or $128.90 more than if you simply collected your interest each year. If you compound semiannually by adding your interest to your principal every 6 months, you'll earn $638.62 after 10 years, or $9.72 more than if you compounded annually.
Compound interest is most effective if you start your retirement investment program early in your career. The longer your interest earns interest, the faster your account grows. One way to take advantage of compound interest is to buy long-term zero-coupon bonds offered by the U.S. government, state and municipal governments, or major corporations. You buy these bonds at a discount from their face value, and you receive the full face value when the bond matures years from now. Until then you don’t see any periodic interest payments, because the interest is added automatically to your principal for the next interest period.
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