Monday, August 29, 2005

Financial Planning for Joe Part II

Last week we took away two very important items from the post: 1) Don't wait to start saving, and 2) Defining goals is the first step.

The absolute hardest part for anyone is simply getting started. I’ll have some ideas in the future, but for now, I think that I need to reinforce take-away number one… DON’T WAIT TO START SAVING. For this we are going to temporarily put aside the Thrift Savings Program (mainly cause I don’t know an incredible amount about it) and focus on saving some of your earnings. Why is it so important to start now rather than later? Compound interest!

A formal definition of compound interest is - interest computed on the accumulated unpaid interest as well as on the original principal. For example, I have $1000 invested that earns 10% annually. Setting aside paying taxes, I will earn $100 in interest the first year. That $100 is reinvested into the original $1K and now stands at $1100. At the end of year two, I will earn $110 in interest and now have $1210. Not investing one more cent for 10 years yields $2,593.74. Not touching it for 40 years yields $45,259.26. Not too shabby for not lifting a finger that whole time… and all it cost me was $1000!

Now, let’s look at what can happen if you constantly invest some portion of your income consistently into an account that can’t be taxed until much later. I plan to talk extensively about Individual Retirement Accounts in later posts. Okay, the law currently allows me to invest $4000 annually into my IRA. If I automatically transfer about $333 of my paycheck into my IRA each month, I hit this number pretty easily. Seems like a lot, I know. Here are how the numbers shake out assuming that: you are 20 years-old, will retire at 65, will always invest $4K a year, and get a return of 10%... $3,163,181! Wow! If you wait till you’re 30, you end up with $1,192,507. Wait till 40, $432,727. See what I mean? These lower numbers may seem big now, but down the road this will be peanuts! $400K at retirement will ensure that you hand out carts at Wal-Mart.

I see my parents struggle. They have followed the formula of their parents… they pay in cash, they don’t trust banks let alone investment brokers, the have always live frugally. Unfortunately, they are now realizing that they will have to work into retirement. They own everything outright, but don’t have the cash coming in to maintain them in their twilight years. Initially, they waited because they were raising a family and there was less information about finance available. We have investment possibilities that weren't available to folks a generation ago. Joe, you just can’t wait. The price that you will pay is waaay too steep. Let your money do the work for you, so that you can relax later!

Want to have fun that illustrates what you can do? Check out this
Compound Interest Calculator.