Compounding is a basic principle of investing. It is the process of earning interest on interest or additional income on reinvested dividends and capital gains.
In particular, compounded growth benefits your contributions to a qualified retirement plan. This is because your contributions to a retirement account are not taxed until you take out the money.
For example, if you invest a lump sum of $10,000 in a retirement account that earns 8% and the account compounds once a year, your investment grows to $14,693 in five years. This $4,693 in total interest income over the five years is an average of $939 per year.
On the other hand, if you receive the interest each year and paid taxes on it, you would only receive $800. Moreover, you would owe income taxes on that money each year.
Your account grows further if the interest rate you earn on a retirement account is compounded more frequently than once a year. If the account is compounded quarterly (four times a year), your $10,000 grows to $14,859 in five years. If it is compounded monthly, it grows to $14,898 in five years.
The following table shows the future value of $10,000 invested for five years at different interest rates and a range of compounding frequencies. Income taxes are ignored:
As the table shows, compounding at higher interest rates leads to larger margins in future values. For example, $10,000 invested at 12% and compounded daily grows to $18,219 after five years. That's $596 more than the $17,623 you earn if compounded annually.
If invested at 10%, $10,000 grows to $16,486 if compounded daily. That's only $381 more than the $16,105 you earn if compounded annually.
The following table shows how compounding favors a tax-advantaged account over a taxable account. In this example, an investor earns $25,000 a year and contributes 10% of her pretax salary every year, at the beginning of the year ($2,500 in the first year). Her salary grows at 3% a year. She is in the 15% income tax bracket. The table shows future values for rates of return of 4%, 6%, 8%, 10%, and 12%, compounded annually for 40 years:
For example, if this investor uses a tax-advantaged account that compounds at an average annual rate of return of 10%, the future value of her account is $996,974. If she pays taxes each year (on the contributions and earnings), it grows to only $635,024.
If your employer makes matching contributions, your contributions to a tax-advantaged account grow even further. (Employers don't receive a tax deduction for contributions to a taxable account so the amount in the taxable account is unchanged.) The following table shows future values for a 50% matching contribution. A 50% matching contribution is when an employer contributes 50 cents for each dollar you put in, up to a yearly limit:
On top of the advantages of tax-deferred compounding, your retirement account receives a huge extra boost from employer contributions. You should seek to contribute as much as you can afford in order to be eligible for as much of these matching funds as possible. After all, these contributions are free money for your retirement, indeed a tremendous employee benefit.
The above information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.