Take advantage of compounding interest when saving for retirement

July 10, 2018

Start saving and investing early in order to achieve your financial goals.

I heard that an early-career physician who plans to retire 30 years from now and wants $10,000 of inflation-adjusted monthly income when they retire will need to save over $8,000,000 for their retirement. That’s a lot of money! How do I get there?

Everyone’s retirement goals are different. First, ask yourself if you really need that much income in retirement. If the answer is still yes, then comprehensive financial planning is going to be critically important. There are many different areas you will need to shore up: emergency fund, disability insurance, life insurance (if you are planning for yourself and a spouse), tax planning, and an investment strategy, to name a few. Some of these items are necessary to ensure that if something negative happens during your career, you and/or your spouse may still be able to save the required amounts necessary to reach lofty retirement goals. Others are just generally good practice and will help you keep more of what you make and earn the required returns on your investments to reach ambitious goals.

However, the two financial concepts that will potentially have the biggest impact on your ability to achieve your retirement goals are compounding interest and saving and investing as soon as possible.

Compounding interest is an incredibly powerful financial concept. It is fundamentally “interest on interest” and helps your investments grow at a faster rate than just simple interest. How does it work? Let’s say you make an investment, and that investment is supposed to pay you interest or a dividend. Instead of taking the interest or dividend payment as cash and sticking it in your pocket, you instead reinvest it back into the same investment. The next time that investment is designed to pay out interest or a dividend, it does so not only on the original principal investment but also now on the reinvested amount.

Think of it as a snowball that you’ve started rolling downhill. As the snowball continues to move downhill, it grows in size and momentum. By the time you reach retirement, this investment-fueled snowball has hopefully grown big enough and has such tremendous momentum that it’s churning out the income you desire on the first day of retirement and the last. The longer you can take advantage of compounding interest before withdrawing the funds, the greater impact compounding interest can have in growing your investment accounts. That’s why starting to save and invest early is critically important.

Next:Save and invest earlyWhether you have modest or lofty retirement income goals, you improve your chances of reaching those goals if you start saving and investing early. Not only does it give you a longer hill to roll your snowball down, it also allows you to compensate for changing investment markets and any changes that might occur to your financial goals as you progress through your career and life.

Also see: Donor-advised funds offer several advantages for charitable giving

Our experience has been that many physicians early in their careers struggle to save. Student loans, down payments for houses, and a general increase in their standard of living consume all their income even though they are making 5 to 10 times as much as they were during their residency or fellowship. It is critically important to find a balance between saving and spending. Create a budget to keep your spending reasonable and free up funds to start saving and investing as soon as possible.

We can’t express enough how critically important this is. Even just saving and investing a modest amount regularly early in your life can have a huge impact on your ability to reach your financial goals.

 

Can I still recharacterize my Roth conversion after the new tax bill was passed?

Unfortunately, the ability to recharacterize Roth conversions was eliminated under the new tax bill. Previously, investors could convert their traditional individual retirement account contributions into Roth IRA contributions and later, if their circumstances changed, recharacterize it back to a traditional IRA contribution. The prime rationale for converting traditional IRAs to Roth IRAs is people feel their taxes may go up in later years and it’s cheaper to pay them now. But sometimes circumstances change after the conversion and people want to recharacterize their investments back to their original classification.

 

Under the new tax law, the ability to reconvert from a Roth back to a traditional IRA is no longer available. You can still convert a non-deductible IRA contribution into a Roth IRA, but the move is now irrevocable.

Send your questions about estate planning, retirement, and investing to Jeff Witz, CFP, and David Zemon c/o Urology Times, at UT@advanstar.com Questions of general interest will be chosen for publication. The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice.