How Savings Accounts Grow from the Magic of Compound Interest

By April Dykman

Have you ever used any of the following excuses as reasons to not start saving for retirement?

  • "I'm young. I'll start saving in five years."
  • "Who cares if my money earns $20 in a savings account? That's not enough to even bother."
  • "I don't make enough money to contribute to my savings."

When you're young, it seems like retirement is too far away to worry about or you don't know how to get started with a savings account. You think you have plenty of time. You think you'll make more money and can start saving later. While you might have decades ahead of you, and your salary is likely to increase over the years, the one thing you can't make up for is lost time. And compound interest gives the biggest returns to those who have been in the game the longest.

Sadly, the trend is that many young workers aren't getting in the game at all. According to a survey by the tax information service CCH, less than a third of eligible workers aged 25 and under contribute to employer-sponsored 401(k)s, and only 4% max out their workplace retirement accounts. What's more, the survey found that just 19% of young workers planned to contribute to an IRA that year, and the majority of those 18 to 24 years of age aren't even sure to which retirement savings accounts they are eligible to contribute.

Saving for retirement just isn't in the minds of most young people--and that's a shame, because starting a retirement savings plan early can really be to your advantage.

Start a Savings Account Now--Waiting Can Cost You

Let's look at the following example: Sarah is 25 years old, and she decides to open a savings account dedicated to her retirement. She plans to contribute $5,000 per year, which is the equivalent of about $417 per month.

  • If Sarah earns a 3% annual return and her bank offers compounding four times a year, by age 65 she'll have $387,095.59 saved for retirement.
  • If Sarah waits five years and opens the account at age 30--and still contributes the same amount and gets the same annual return--she'll have $310,054.26 saved by age 65. The difference between starting at age 25 and starting at 30 is $77,041.33!
  • If she waits even a few more years--say, until she's 35--she'll have just $243,707.04 in the savings account when she retires.

Even if Sarah "catches up" with those missed $5,000 annual contributions when she's 30 or 35, her total won't be as high as when she starts saving regularly at age 25. The difference is due to compounding.

Compound Interest Favors the Young

Sarah can see big returns by starting at age 25 because of the magic of compound interest. Compound interest works like this: Over time, each dollar you invest earns interest. Then the interest you've earned becomes a part of your principal, and in the next period, you earn interest on that as well. Your interest earns interest.

It might seem like you aren't earning very much in the beginning, but short-term earnings aren't important. It's the long-term--30 or 40 years from now--where you'll see big gains.

Take the example of Sarah's initial $5,000 investment. Even if she stopped contributing new money, after two years she would have $5,307.99, which means she'll have made $307.99 on her investment over those two years. After investing that $5,000 for 40 years, though, she'll have $16,526.42 total, or $11,526.42 on her first year's investment. Again, that's without adding any more new savings. That's a serious chunk of change!

If Sarah invested retirement funds in an IRA or other brokerage account, it's possible that she could get even higher average annual returns--which would magnify the effect of compounding--and probably receive tax advantages to boot. Of course, higher returns come with higher risk, but the point is still that starting early is the key to reaping the gains of the magic of compounding.

With Retirement Savings Account, Every Little Bit Helps

You might be thinking, "Well, that's great for Sarah, but I don't have $5,000 per year to save!" The problem with that line of thinking is that you'll always wait for a "better time" to get started, and in the process you'll never start at all.

Socking away money in a retirement savings account is not an all-or-nothing deal. Start small, with whatever you can contribute - even saving spare change helps! Set up automatic contributions so that the money is invested before you can spend it elsewhere. As your income increases, you can increase your contributions. If you get a raise, add to your monthly investment rather than increasing your living expenses. This prevents lifestyle inflation that often further defers retirement savings. In other words, if you get a raise and decide to treat yourself to a brand new sports car, those brand new sports car payments will likely bring you back to square one--not enough cash to save for retirement.

It literally pays to get started today. And one final bit of advice: once the money is invested, don't touch it! The magic of compound interest will only work if the money is left to grow in your savings account.