Key Takeaways
- Compound interest is a powerful way to grow your money.
- The Rule of 72 helps you calculate when your money will double.
- When faced with the choice, grow (and take!) the bigger pile of money.
Albert Einstein is credited with saying that compound interest is the eighth wonder of the world. While it’s not a certainty that he said these words, one has to agree with the sentiment. Compound interest makes a huge difference when you’re trying to grow your money.
This can be demonstrated when we look at the unfortunate trend of people taking money out of their 401(k)s. Perhaps they need some quick cash, so they withdraw the money – but when this happens before a person hits age 59 ½, there’s a 10% penalty on full deductible monies.
Depending on the state you live in, this money may be subject to state taxes. It’s also definitely federally taxed. Depending on your tax bracket, you can expect at least 40%, and upwards of 50%, going toward taxes and penalties. That’s a huge cut!
Moreover, the money is now in a taxable environment because you’ve taken the money out instead of keeping it tax deferred. Why is this a big deal? The number one issue is that you were saving that money for the long term. There must have been a reason for the shift – perhaps a short-term need. But try seeking another solution if you can. Let’s look at compound interest to shed some light on why this is important.
There’s a thing called The Rule of 72 and there’s an easy way to think about it. You take 72 and you divide it by an interest rate, and the result gives you the number of years it will take for your money to double. For instance, if you have money growing at 7%, you divide 72 by 7 and you’ll get about 10, meaning that it will take 10 years for your money to double.
Knowing this, let’s say you have $10,000 in your 401(k) when you’re 30 years old and you want an idea of how much you’ll have when you’re 60. Using The Rule of 72, we know that by age 40, that money will grow to $20,000. By age 50, it’ll be $40,000. And by age 60, you’ll have $80,000.
Now, let’s look at what happens if you take that money out of your 401(k) and you decided not to spend it, but invest it instead. You pay all the taxes and decide to forego the compound interest you would’ve gotten in your 401(k). Right off the bat, 40% of that $10,000 goes toward those taxes and penalties. You’re left with $6,000 and it’s in a taxable environment, so it’s no longer 7% interest, but roughly 5%.
The Rule of 72 tells you that it will take approximately 14 years for your money to double when the interest rate is 5%. If you’re 30 years old and starting with $6,000, this means you’ll have $12,000 at age 44, and $24,000 at age 58.
So, comparing the two, you either have $80,000 at age 60 or $24,000 at age 58. What a difference! Conventional wisdom would say that when given the option between two piles of money, take the bigger pile.
If you’re going to pull money from a 401(k), think about the long-term effects. Compound interest makes a big difference for your future. Until next time, enjoy.
Gary
If you’d like to read more on this topic, here are a few of Gary’s previous posts that you might enjoy:
