Albert Einstein is credited with calling compound interest the "eighth wonder of the world." And when you understand how powerful it can be, you begin to understand why. With debt, compound interest works against you from manageable to "Oops, I might be in trouble." But with investing, compound returns (the positive counterpart of compound interest) can do a lot of the heavy lifting for you to create wealth and get on a path to millionaire status.
For compounding to work its magic, it needs time. Imagine a scenario where four different people make a single $10,000 investment averaging 10% annual returns until they turn 65 years old. Here's how much that $10,000 would be worth based on the age they first invested:
| Age of First Investment | Years Until 65 | Amount |
|---|---|---|
| 55 | 10 | $25,900 |
| 45 | 20 | $67,200 |
| 35 | 30 | $174,400 |
| 25 | 40 | $452,500 |
Data source: Author calculations.
Notice how the earlier your starting age is, the greater the difference in total dollar amounts earned over time. The 10-year gain between 45 and 55 is just over $41,000; the 10-year gain between 35 and 45 is just over $107,000; but the 10-year gain between 25 and 35 is over $278,000. That's because compound interest has a greater impact with the more time it has to work.
Image source: Getty Images.
It's all about consistency
Rarely do people retire millionaires strictly by saving money. Even if you worked for 50 years, you'd have to average $20,000 in savings each year. That's a tough ask -- especially considering most people retire in their early to mid-60s. Instead, it's about making consistent investments and allowing time and compounding to cover most of the bulk.
Let's imagine you averaged a 10% annual return (the historical long-term average of the S&P 500). Here's how long it would take you to cross the $1 million threshold based on different monthly investment amounts:
| Monthly Contributions | Years Until $1 Million | Total Contribution |
|---|---|---|
| $500 | 31 | $186,000 |
| $1,000 | 24 | $288,000 |
| $1,500 | 20 | $360,000 |
| $2,000 | 18 | $432,000 |
Data source: Author calculations.
Even at just $500 monthly, you can accumulate over $1 million in 31 years -- fewer years than the average person works in their lifetime -- while only personally contributing $186,000. If you're off to a later start and don't have 30 years, that's fine, too; a boost in monthly contributions to $1,000 can shave years off the time it takes to accumulate $1 million. Or, if time is on your side and you're financially able, you can add to the effects of compound returns. Investing $2,000 monthly for 24 years at that 10% return puts you over $2.12 million.
Of course, there are no guarantees in the stock market. There's no way to predict your average returns over decades, but history has shown that the market tends to reward investors who are patient, consistent, and investing in major indexes and blue chip stocks for the long haul. You likely won't get to millionaire status by just saving, but you can bet you'll be in a much better position by giving yourself a chance in the market.
Save money on taxes
A Roth IRA is one of the best resources you can utilize when saving for retirement. Since you contribute after-tax money into a Roth IRA, you get to take tax-free withdrawals in retirement. You can buy any stock in your Roth IRA that you would in your brokerage account, but the tax-free withdrawals can easily save you thousands of dollars in the long run.
If you contributed $500 monthly into both a Roth IRA and a brokerage account averaging 10% returns over 20 years, you would have accumulated over $343,650 while only contributing $120,000. The difference, however, is that in your brokerage account, you would owe taxes on the more than $223,600 in capital gains earned during that time. In your Roth IRA, the whole amount would be yours, free of taxes.
The income limit for contributing to a Roth IRA is $144,000 ($214,000 if married and filing jointly). If you're eligible to contribute to a Roth IRA, you should contribute up to the allowed limit based on your income, and then invest your money in there before doing so in your regular brokerage account. For example, if you plan to invest $10,000, the first $6,000 (the 2022 Roth IRA contribution limit) should be in your Roth IRA, and the last $4,000 should be in your brokerage account. You'll likely want to prioritize your Roth IRA because of the tax break. You'll thank yourself later.
