THE POWER OF COMPOUNDING INTEREST
What Would You Do With $1,000,000 Tax-Free?
Albert Einstein once said, “Compound interest is the most powerful force in the universe.”
Whether or not you agree, it can be thought-provoking.
I will show you how to employ this powerful force to create $1 million in tax-free net worth.
How does compounding interest work?
First, think of simple interest.
If someone borrows $1,000 and pays you 10-percent in one year plus your principal, then in one year you would have $1,100. If instead they borrowed the money for two years at simple interest, they would owe $200 in interest, plus the principal. The amount stays the same each year.
Now, let’s add the power of compound interest.
However, if the interest were compounded annually, then the interest in year two would be based on a principal of $1,100, so the interest in year two would be $110. So each year the interest would be increasing as the principal grows. And at the end of two years you would have received a total of $210 in interest.
The extra $10 doesn’t sound like much at the end of year two, but give it time and you will get to an extra $1 million. Keep reading.
THE RULE OF 72
A simple tool, the Rule of 72, can be used to determine the future value of an investment. For example: Take $1,000 invested today at 10%. 72 divided by 10 equals 7.2. The investment will double to a value of $2,000 in 7.2 years. The investment doubles again to $4,000 in 14.4 years. It becomes $8,000 in 21.6 years, then $16,000 in 28.8 years.
CONTRIBUTE $5,000 IN A ROTH IRA
Suppose, instead of $1,000, you contribute $5,000 to a Roth IRA account. A Roth IRA enables all of the growth to be accessible tax-free at a later date. Note that $5,000 is less than the maximum contribution, but easy on the math:
$5,000 invested today at 10 percent will be worth $10,000 in 7.2 years.
$20,000 in 14.4 years
$40,000 in 21.6 years.
$80,000 in 28.8 years.
After 28.8 years the initial $5,000 investment grew by $75,000!
Suppose you contributed $5,000 at the beginning of every year, starting with your 24th birthday:
Year 1 contribution becomes $95,972 on your 55th birthday, after 31 years.
Year 2 contribution becomes $87,247
Year 3 ……………………………………. $79,315
Year 10 ……………….…………………. $40,701
Year 20 ……………………….…………. $15,691
Year 31 ……………………………………$ 5,500
Total after 31 years would be $1,000,689.
So, by your 55th birthday you would have gained $1 million tax-free in your Roth IRA. And your contributions were only $155,000. Not bad! Einstein was right. Compound interest is a very powerful force in the universe.
TAX FREE INCOME PLUS
This could provide a tax-free income of $50,000 per year and still grow the principal at 5% a year to protect against inflation. This is considered a conservative withdrawal rate by many financial planners.
It also illustrates a simple way to become a millionaire, provided you have the discipline to start and continue investing and the time to grow your investments. One of the most striking revelations is how much the first contributions grow compared to the contributions made during the “catch up” years. How much does it cost you to delay by one year investing $5,000 in your financial future? Could it be a year of financial freedom?
Please note that it is possible to achieve rates of return significantly higher than 10 percent using leveraged real estate, notes, or options. That would enable someone to achieve a desired benchmark or goal sooner. Returns on rental property should also be recalculated each year based on the equity of the property. The examples above use rates of return attainable by reasonable and prudent investors.
How are you harnessing the power of compound interest for your financial freedom?
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.