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I VIVIDLY REMEMBER my father explaining how small sums of money could grow exponentially. Using the example of a penny that doubled every day for a month, he showed how it could grow to more than $10 million. Indeed, as Albert Einstein didn’t say, “The most powerful force in the universe is compound interest.”
Many authors tout the benefits of saving beginning at a young age. Radio personality Dave Ramsey and his daughter Rachel Cruze, for example, compare two individuals. One starts saving early and puts aside a modest sum annually for eight years, and then stops. The other begins eight years after the first, investing the same modest amount for 35 additional years. The first person comes out ahead.
Admittedly, their eye-popping conclusion depends on an absurdly high 12% constant rate of return. No investment can guarantee double-digit growth rates year after year. Certificates of deposit and some bonds might offer consistent returns, but rates tend to be relatively low. The stock market can deliver much higher returns, but not with any predictability.
That brings me to our twins. They graduated from college in 2016. I figured this was a good time to take advantage of their youth and start them on the path to wealth. I talked to them about compounding, and how powerful it can be when combined with early and consistent savings.
The idea was to have them amass a relatively small amount in tax-deferred accounts prior to age 30. As I explained it, they could “go big early” and then ease up on the gas. This wasn’t a free pass to skip investing once they reached their initial goal. Rather, the idea was to set aside a basic sum to fund their life many decades later. They liked the concept.
Together, we set a goal of saving $3,750 a year in an IRA. As an incentive, my wife and I promised to contribute half that amount, meaning they’d need to save roughly $150 a month to reach the annual goal. If all went according to plan, they would have socked away $30,000 by the time they turned age 30 seven years later.
They’d then leave those savings to grow for 35 additional years. Two rules were implicit: The amount set aside was untouchable and dividends must be reinvested.
To get an idea of the power of compounded savings, I had them plug numbers into an S&P 500 return calculator, looking at some random 35-year periods. They were astonished at the final numbers.
For instance, the 35-year period ended March 2024 had an annualized total return of 10.19%, similar to the S&P 500’s average annual 10.26% return since the index’s 1957 inception. A $30,000 initial investment would have grown to a final portfolio value of $900,000. This figure isn’t adjusted for inflation, and it includes reinvested dividends.
I then discussed the income this portfolio might generate for their 65-year-old selves, assuming a 4% withdrawal rate. They’d have some $36,000 a year to begin retirement—not all that high, but certainly nothing to sneeze at. The amount represented $6,000 more per year than the entire initial investment.
A lightbulb went off in their heads. What if they continued to save after the initial seven-year saving period? A mere $200 per month, or $2,400 per year, through the 35 years to age 65 would goose results to over $1.54 million, giving them an initial retirement income of just north of $61,600 per year. What if they invested $500 a month? That would become more than $2.5 million dollars, providing over $100,000 per year.
Before they got too excited, I noted that projected outcomes weren’t guaranteed. Looking at all 35-year stretches, the S&P 500 has produced an average annual return of 6.6% after inflation. Still, there were no 35-year periods when the S&P 500 lost money.
The twins agreed to try the concept. We sat down together each year to make their contributions and to discuss the investment plan. Initially, they invested in SPDR S&P 500 ETF Trust (symbol: SPY).
This past March, they turned 30 years old. During the initial time, their accounts benefited from a strong annualized return of more than 13%. The positive early growth solidified their decision to stick with the plan.
There were tweaks along the way. For example, my daughter started medical school and had no income to contribute in two of the first four years. She made additional contributions when she began her residency. The twins decided to slightly broaden their portfolios by purchasing Vanguard Total Stock Market ETF (VTI) and Invesco’s technology-heavy Nasdaq-100 ETF (QQQ). They switched to Roth IRAs to take advantage of their lower income tax brackets. Recently, they’ve started saving the maximum allowable IRA contribution.
As Einstein also didn’t say, “Compound interest is the eighth wonder of the world. He who understands it, earns it.” The combination of starting early, saving regularly and compounding is indeed remarkably powerful—and you don’t have to be a genius to benefit.
Jeffrey K. Actor, PhD, was a professor at a major medical school in Houston for more than 25 years, serving as an academic researcher with interests in how immune responses function to fight pathogenic diseases. Jeff’s retirement goals are to write short science fiction stories, volunteer in the community and spend time in his garden. Check out his earlier articles.
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I applaud your planning and good intentions.
But it needs to be said – the ‘power of compounding’ only works if the market is yielding positive returns after inflation and investment costs. There’s no reason to believe this will continue. “past performance is no guarantee of future results”, as every mutual fund will tell you. So I rather disbelieve in the power of compounding, which only works in an abstract mathematical sense, or as long as number go up.
My experience with saving lots before the age of 30:
the S. African stock market had negative return over fifteen years, while inflation ran in double digits and the currency devalued. This utterly wiped out ten years of retirement savings. I should have bought a sports car instead. With reasonable maintenance it would still have been worth a couple of thousand, and I’d have had all the fun of driving it.
The power of compounding works in reverse too, when the markets are going down. The concept which is mathematically sound, unfortunately breaks down on the assumptions that are required – low inflation, steadily increasing market indexes, skillful stock picking/mutual fund picking. These may not happen..
But, it’s the only game in town, and we have to play it, with our hearts in our mouths for decades on end..
Here is another idea to convince others.
Compare:
25-year person saves $1000 monthly for 10 years and stops.
35-year person saves $1000 monthly for 30 years.
10 vs 30 years assuming the same rate of return.
Who would have more money at age 65? the 25-year
I helped my son open a Roth IRA when he was 15 when he started his first job at a local bike shop. All of his earnngs went into bikes and parts, so his mother and I funded it until he finished college and started work. I have managed these funds, which are allocated roughly 70%/30%, and have generated very positive returns since inception. What started out as a little money has, largely through compounding, become a not insignificant future retirement fund. The two simplest rules of investing: save early, save often, are indeed the keys to successfully building long term wealth.
Wonderful! In our case, we went full throttle at 100% equity allocation. Along the way I taught them that there are no guarantees, but they also had time on their side. For now, it seems to have worked. They can throttle back on % equities later in life. And now that they are adults, they can tweak the allocation to allow for their own independent risk tolerance.
Did something similar with my son who graduated close to the same time. Not as detailed as you and my proposal was Roth. He continued to add and is now making too much for the Roth IRA but continues at his company’s Roth 401k. As you noted, the “kids” did well this past 9 years or so. My hope is that the flexibility this creates for them is what’s most important as it’s many years down the road for retirement.
Your son can always use the back door Roth if he wants to keep contributing to his IRA.
I gave each of my four children a modeling contract (yes in writing) with one of our family LLC’s… I then opened up a ROTH IRA for each and have been maxing it out starting from around the age of 5. Our goal is to continue to do this until they’re 30. I’m in year five now. It’s split 50/50 in VTI and VT. The kids don’t have any idea yet about the money and once they’re of a certain age I’ll explain that this is part of their inheritance… a comfortable retirement if they don’t meddle with it!
Very cool! We start things in life and want to pass along our good judgments to the down stream.
I’m taking my own Roth distributions and gifting my two sons that are instructed to fund their own Roth IRAs.
I like the idea of hiring your children, to be employed and help them retire. Hey, I know children can be great models!
Sounds like a couple of parents are also being great models for their kids!
This is precisely why I insisted my kids open Roth IRAs and buy a total stock market fund with div & cap gains reinvested the instance they had taxable earned income. But I didn’t describe why as clearly as you. I forwarded them your article. Thank you!
Great that you got your kids started so well. Growing up in England investing wasn’t on my radar – people expected pensions and the equivalent of Social Security would be enough (and it was for my parents). I didn’t start saving seriously until my early 40s, when I realized my pension wouldn’t have a COLA, but compounding still worked its magic.
Not just an English problem. In my humble opinion, most US citizens seem to ignore compound thoughts, assuming that social security will solve all their future financial challenges.
Compounded Interest-the 8th Wonder of the World
Started Roths for my kids as young teenagers with office jobs and now at 350k in late 40’s
Your twins are indeed lucky to have a dad who explained this to them and helped them get started. So many kids aren’t as fortunate—another reason why basic personal finance needs to be taught in our high schools and colleges.
If your goal is to leave a legacy for your children, is it more beneficial to provide them with an inheritance after a long life, when they are likely well into middle age, or to gift them $18,000/yr/parent now, in hopes that they learn to handle investments prudently at a young age? I prefer the latter approach, but I am curious to hear what others think.
Mark, I look at it as two different goals. Sure, we started the twins with small matching gifts directly to their IRAs to get them going. But it worked in that they are now exploring long term financial concepts on their own. Now that we are retired, we have begun ramping up yearly gifts (with no strings attached). Starting small, with hopes to increase over time if the markets are good to us. Perhaps a bit of both ideas, short and long term, is a good middle ground.
So simple, yet so profound. Such a wise and caring Dad! I would suggest it doesn’t have to start so early and it doesn’t need to start big. My Pilates trainer has been my friend and confidante for 12 years now. She is a 42-year-old health center employee who nets about $50 an hour and I knew she didn’t have a retirement plan. As a Christmas bonus, I opened a Roth for her four years ago with just $200, an amount that with her mother’s help she continues to add to her account monthly. She has about 23 years until retirement. At an average rate of appreciation of 11% over 27 years she should amass a nest egg of about $350,000. She still doesn’t believe me.
Steve, You are a good man to help start her down that path. Indeed, your moral compass points in the right direction.
One thing I would add to this discussion is that compound interest can still work its magic for those who don’t begin seriously saving until they are older. This is especially true because most folks are able to save increasingly larger amounts as they get older. For example, someone who begins making maximum retirement contributions at age 40 and retires at 65-70 will still benefit greatly from compounding.
That’s probably closer to norm for those who save. I myself began later, and was able to increase contributions as I got older (…and wiser…?).
This is a great story! Congrats to you and your entire family for lessons well-learned!
Thanks!
My late father (a former business professor) and I (very money savvy) tried the same experiment with my niece (dad’s granddaughter) when she turned 18. We explained carefully what was the plan and she eagerly agreed to it. Dad and I each contributed $1000 ($2k was the max allowed then.)
The instant my niece saw the money in her Roth IRA, she harvested it and closed the account.
Bad genes?
A sad tale. She killed the goose that lays golden eggs. Grandpa, Grandma, aunts, uncles unlikely to make further cash gifts.
Not so uncommon, the poor judgement, as it seems our higher reasoning functions don’t fully mature until mid-20s.
Hopefully a one-off and not a portent for the future.
Ouch! Know that your plan was a solid one, even if it didn’t turn out the way you hoped.
Oh no, that’s terrible!
Your twins are lucky to have parent attuned to finance and saving. Sadly most kids don’t have such person in their life to pass on this knowledge.
Agreed. My Dad was a buy-and-hold guy. I became that same investor, except that he did his with stocks and I do mine with mutual funds and ETFs.
Dan, Indeed, I was truly blessed with having a father who passed some of his wisdom to me. I consider it lucky that my twins were open to learning a few tricks from their old man.
Jeff, great job guiding your twins to early savings habits. My younger self didn’t think much about the value of front-loading my retirement savings. I’m glad I did something though…my records indicate I had put away $8,782 of my own money in my 401(k) by the time I was 30. It had ballooned to a princely sum of about $13,000 by that time due to my brilliant investing strategies (sarcasm intended). Fortunately, the light bulb went on shortly thereafter.
Ken, I commend your efforts! That’s a pretty tidy amount you were able to tuck away for your future. Probably more than most of your peers. Definately more than I had socked away by that age.
Jeff, did they make the $30,000 by 30 goal?
Dick, Yes, they did. In fact, they blew by that number a few years ago. They even ended up maximizing their Roth contributions in the final half of the trial. It certainly helped that they caught a strong market ride in the beginning. Also, they were not detered when COVID hit because they saw a long term goal, and trusted that they were buying shares at a discounted price.
Jeff, my father also challenged me with the penny riddle, as I did my daughter. The power of compounding is counterintuitive, but is indeed a wonder. Good article illustrating the concept.
Ed, Thanks! It is indeed amazing when one stops to contemplete the concept.