How Compounding Can Help You Retire a Millionaire -- Even on a Modest Income

As someone who didn't learn about personal finances until I was an adult, the fact that each of my three granddaughters has been investing since age four or five makes me very happy. A portion of each month's allowance goes toward buying stock slices. I know they're just beginners and will make mistakes, but all the same, I was recently thrilled to hear the seven-year-old describe compound interest.

The earlier you learn to harness compounding -- also known as compound interest -- the closer you are to retiring a millionaire, no matter how much money you earn.

Image source: Getty Images.

What is compounding?

I love the simple way the Consumer Financial Protection Bureau describes compound interest. "Compound interest is when you earn interest on the money you've saved and on the interest you earn along the way." The same holds true for compounding generally. You invest to get a return, and then the return itself generates additional return.

Say you start with $1,000 and earn a 5% return annually. After the first year, you will have earned $50, which is nice, but no great shakes. The second year, you'll earn a return on both the $1,000 initially invested and the $50 in earnings, producing $52.50.

It's like a snowball rolling downhill, picking up speed and steadily growing.

Don't fall for the myth that you have to be wealthy to begin with

We've all heard of billionaires who've lost it all and school janitors who leave a small fortune behind. How much you earn isn't nearly as important as how you manage the money.

Let's say you're 35 and earn $50,000 a year. You recently paid off high-interest debt and carefully follow a monthly budget. Your goal is to retire at (what's now) your full retirement age (FRA) of 67.

You've worked your budget, and believe you can contribute $500 monthly to your employer-sponsored 401(k) ($115 per week). Your goal is to slowly work your way up in your field and plan to increase your contribution by 10% every two years. In other words, you'll contribute $500 monthly in years one and two. In years three and four, you'll increase the contribution to $550 per month, and so on. ($500 x 0.10 = $50) ($500 + $50 = $550)

Following this plan allows you to slowly build a comfy nest egg.

Source: Author calculations with rounding. 

You may get a boost from your employer

Among companies that offer 401(k) plans, 98% also provide matching contributions. Those matching contributions usually range from 4% to 6% of your salary. Let's say your employer matches 4%. Since you earn $50,000 annually, your employer will add $2,000 annually to your 401(k).

As long as you stay with the same employer long enough to be vested (usually three to five years), your retirement account will grow even faster.

Only worry about what's right in front of you

It would be easy to look at the contribution table above and immediately think, "There's no way I'll be able to contribute $975 a month in 15 years." Your challenge is to build your castle one brick at a time. Don't focus on anything but the portion of the castle you're working on now. You'll find it easier to stick with the plan if the only contribution goal you have to meet is this month's.

You have a couple of things working in your favor. First, if you're contributing $500 monthly, that's in pre-tax dollars. That means the $500 comes right off the top of your income, saving money in payroll taxes.

Plus, if you have trouble coming up with that $500 right now, you can take advantage of any matches your employer offers.

Suppose you aim to contribute $500 per month ($6,000 annually) and your employer matches 4% of your income ($2,000). If you're in a financial bind, you can contribute $4,000 annually instead ($333 per month or $77 per week) and let your employer cover the remaining $2,000, thereby maintaining your plan.

You don't have to be a highly compensated employee to build a nest egg of over $1 million. You just need to come up with a plan you can stick with.