Financial Answer Center
- Time Value of Money
- The Power of Compound Interest
- Dollar-Cost Averaging
- Pre-tax, After-Tax, Tax-Deferred, and Tax-Free
- The Effects of Inflation
In order to make informed decisions about 401(k) plans and other retirement savings strategies, you need to understand some basic financial concepts. One of these is the time value of money, the idea that money should increase over time. One good way to achieve this is using compound interest, where interest earned on the principal in an account is put back into the account, where it also earns interest.
Dollar cost averaging is a strategy for reducing risk when you invest over time. You will also need to understand the effects of inflation, and the differences among pre-tax, after-tax, tax-deferred and tax-free.*
The concept of time value of money is that, over time, you should earn interest on your money. Money invested in interest bearing vehicles begins to grow as soon as it's invested. The earlier you start investing in your 401(k) plan, the more time your money has to grow.
Look at the following chart to see the value in starting early:
|Starting Age||Ending Age||Total Contributed||Years Contributed||Estimated Value at Age 65|
- Employee #1 and #2 each contribute $1,000 per year for 10 years.
- Rate of return - 8%.
- Money is growing tax deferred in a 401(k) plan.
- All interest and gains are reinvested.
Doesn't look right, does it? Depositing the same amount of money ten years earlier will give you twice as much money at age 65. This is the result of something called compound interest. The interest and gain you get on your money over the years keeps getting reinvested and earns more interest. Your principal earns interest and your interest earns interest. Over time it makes your money grow faster and faster. And the more years you have to make this compound interest cycle work, the more money you'll have when you retire. Use the time you have to your advantage by saving now and saving more.
*Dollar-cost averaging cannot guarantee a profit or protect against a loss, and you should consider your financial ability to continue purchases through periods of low price levels.