A financial basics refresherBy Jason Alderman
Until you get in the habit, putting aside savings is never easy. But the sooner you start, the sooner you'll start seeing results. As you'll see below, when it comes to savings, time is your best friend:
The power of compounding. When you reinvest interest earned on savings accounts or other investment vehicles, the interest grows (compounds) the account's value much faster than if you withdrew it. For example, a one-time $10,000 investment earning 6 percent a year would grow to $17,908 in 10 years if you reinvest the interest; after 20 years it would be worth $32,071 and $57,435 after 30 years.
Regular investments. You needn't start with such a large initial investment to reap big rewards. Say you're 21, start with a zero balance, save $100 a month, earn 6 percent annual interest and reinvest the interest. After 10 years you'd have $16,470; $46,435 after 20 years and $100,954 after 30 years. If you retire at age 66 your account would be worth over $276,978 – all for a $100-a-month investment.
Timing is important, however. Postponing your savings by only two years would reduce your balance in 20 years to only $38,929 – more than $7,500 less. Wait five years to begin saving and your balance would drop to $29,277 in 20 years.
Tax-deferred savings. Another way to accelerate earnings is to take advantage of tax savings offered by retirement savings programs like 401(k) plans and IRAs. With a 401(k), you can contribute up to $16,500 a year (or $22,000 for those 50 and older) on a pre-tax basis. This lowers your taxable income – and therefore your taxes – and allows your account to grow tax-free until you withdraw the money at retirement.
Regular IRAs offer similar pre-tax advantages; or, you can contribute to a Roth IRA using after-tax dollars and your earnings will be completely tax-free at retirement. The annual IRA contribution limit is $5,000 ($6,000 for 50 and older).
Practical Money Skills for Life, Visa Inc.'s free personal financial management program, features a guide to 401(k) plans at www.practicalmoneyskills.com/benefits. To learn more about IRAs, visit www.irs.gov.
Risk. The riskier an investment, the greater your potential gains – or losses. For example, savings accounts offer lower interest rates in exchange for minimal or no risk, whereas stocks potentially can earn double-digit investment rates over long periods of time, but at much higher risk.
Inflation. Inflation measures the rate at which goods and services increase in cost over time. If your investments earn 2 percent interest but the inflation rate is 3 percent, the net result is a 1 percent loss. That's why many financial experts often recommend that people with at least five to 10 years until retirement keep a portion of their savings in higher-risk investments like stocks and bonds; otherwise, it's hard to stay ahead of inflation.
Keep in mind that no matter how much interest your investments earn, if you carry forward credit card or loan balances (aside from tax-deductible mortgage interest), you'll be eating into whatever profits you might make. For tips on managing credit cards and debt, visit Practical Money Skills for Life's Credit and Debt site (www.practicalmoneyskills.com/credit).
This article is intended to provide general information and should not be considered tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how tax laws apply to your situation and about your individual financial situation.<< Back to Practical Money Matters
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