Part 4: Compounding interest – Strategies toward wealth

Overview
This is the fourth article of a series covering compounding interest. This series is meant to help investors understand the importance of having money work for you through the power of compounding. The first article provided an overview of compounding by considering the analogy of growth in memory chip transistors since the early 80s. The second article provided visualization of compounding over 40 years against a single initial $1,000 investment. The third article provided visualization of compounding over 40 years against consistent investment of $1,000 yearly split over 12 months. In this article, we will cover several strategies toward wealth leveraging the power of compounding interest in a tax free account.

Disclaimer
The same assumptions in the disclaimer of the second article will be used here as well.

Recap of the previous two articles
In the second article, I showed how a single $1,000 investment at age 25 could grow significantly over 40 years to $2,224 at 2%, $4,940 at 4%, $24,273 at 8%, and $576,923 at 16% interest. My goal was to show that even one small investment can grow significantly over time as the interest earned starts earning more interest which then earns even more interest. The compounding effect becomes more pronounced as the rate of interest goes up since there is more money generated from interest each year which then continues growing at a faster rate. That is the power of compounding. Eventually your money earns more money which then earns even more money. In this case, all you did was provide the small initial contribution. Your money then went to work for you to provide the rest.

In the third article last week, I showed the importance of consistently contributing funds into your tax free account. Using the example of investing a total of $1,000 each year, split over 12 months, you can see the significant difference in the 40 year compounding period to $61,203 at 2%, $98,497 at 4%, $290,917 at 8%, and $3,599,519 at 16% interest. To see the effect of interest earned upon previous interest earned, lets take out all of the contributions the investor put in. Over 40 years, $40,000 was invested ($1,000 per year). Now remove $40,000 from each total to get $21,203 ($61,203 - $40,000) for 2%, $58,497 for 4%, 240,017 for 8%, and $3,559,519 for 16% interest. All of these totals were due to compounding of interest at the different rates.

Lets look closer at the effect of compounding
To further show the power of compounding, lets take a closer look at the difference between the different interest totals. As stated in a previous article, you would expect the 4% interest total to be twice as large as 2% total. In fact, the 4% interest compounding total of $58,497 is almost three times more than the 2% interest compounding total of $21,203. The effect is seen even more as we compare the 8% interest total of $240,017 to the 4% interest total of $58,497, a little over four times as much. The 16% interest total of $3,559,519 is nearly fifteen times the 8% interest total of $240, 017. So, even though the difference between each interest is twice the next level, the resulting compounding interest earned goes from nearly three times the amount (between 2% and 4% totals) to almost fifteen times the amount (between the 16% and 8% totals). If I carried this further to 32% (twice 16%), the resulting interest compounding would be staggering. This is why the best sophisticated accredited investors strive to, and many do, consistently earn strong compounding rates on their total investment portfolio.

The yearly COLA strategy to increase your contributions
Looking at the importance of having interest earn interest upon interest, it makes sense to try and get as much money into your tax free account as possible in the early years. It would be great if a 25 year old employee would have enough free cash for investing at the full IRS contribution limit ($16,500 for 2009). Starting out at the age of 25 with such a strong start contributing $16,500 yearly would produce significant ending balances after a 40 year career of $1.4M at 2%, $3.2M at 4%, $15.9M at 8%, and $376M at 16%. However, not many new employees have the ability to start out investing so much of their salary. Therefore, I suggest starting out small and working their way up through the yearly half Cost of Living Adjustment (COLA) strategy.

Every year most employees get some amount of yearly salary increase due to inflation (a.k.a. COLA in some professions). I realize these unusual economic times mean many will not, but I will assume those times will get better soon to where the usual increases will return.

COLA strategy variation #1 – half of the COLA into investments
With this strategy, the employee would increase their tax free account contributions by half of this increase each year. As an example, if the employee receives a 2% salary increase, then he or she would increase contributions into the tax free account by 1% (1/2 of the 2% pay raise). This way contributions are increased without the employee missing the money. As a bonus, the employee also gets the remaining money as an increase. In actuality, the employee would see more than a 1% increase since the 1% contribution into the account comes before taxes.

COLA strategy variation #2 – full COLA into investments
Since funds invested in a tax free account are usually before tax, you could put the full COLA into your tax free account and still get an increase in salary. If the employee put the full 2% into the account, he or she would still get a take-home salary increase since the COLA increase is not taxed when being put into the account. The employee should strive to continue this strategy until the yearly IRS contribution limit has been reached. At that point, continue contributing at the IRS limit as it changes each year. That hard work is then done since the employee would be at maximum contributions and have a strong habit of saving/investing money.

Lets look at an example:
If the employee was in a 30% tax bracket and making $50,000 per year, the 2% COLA raise would be $1,000 (2% of $50,000). If the raise is not put into the account, then the employee would pay 30% of the $1,000 in taxes, or $300. By putting the full $1,000 into the tax free account, the employee saves the $300 in taxes and therefore will increase the yearly take-home salary by this amount. The end result is the employee has increased contributions each year in the account while also still enjoying an increase in take-home pay.

The “Automatic Pilot” strategy to wealth
Rather than contributing a set amount into your tax free account yearly, have the contributions put in auto-pilot. As mentioned above, most people get a raise each year. It would be easy to forget to increase your tax free account contributions if they were set at a specific dollar amount. Instead, contribute a percentage of your salary into the account. That way, as your salary increases, so does your contributions. In this case, if you get a 2% raise and contribute 10% of your salary into the tax free account, then your contributions would go up by 10% of the 2% salary increase. Just be careful not to let your contributions grow to exceed the yearly IRS contribution limit.

Summary
As we have seen over the course of this series on compounding interest, compounding is a key strategy to generating wealth. The more you can get your money to work for you, the sooner you can reach our financial goals. I hope these articles on compounding have provided insights through the various examples that may not have been that obvious before. This is why so many financial advisors highly recommend that the one of the first investment goals of any investor should be to maximize their tax free accounts. You may think a $2,500 yearly contribution into an IRA account may not grow into much. As you can see in these articles, it can grow into a significant amount, even if you don’t invest in anything else. Having a strong habit of investing into these accounts provides a strong foundation toward becoming a truly successful investor. Hopefully, your account balance will grow large enough for you to become accredited and have access to other investments that are not available to the ordinary investor. The key is being a disciplined and consistent investor with strategies and goals that define a plan of action toward wealth.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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