Retirement: 5 Ways Money Makes Money

Posted on December 22, 2014 at 12:40 PM PDT by

Saving for retirement is hard work, especially starting out. It’s no picnic to sock money away you might spend instead.

But you have to do it, and the earlier the better. Getting started with retirement saving and investing is common sense, but the really important part is starting early.

Why? Because time is money. You have to save and you should increase your saving levels as your income level rises over the years. But it’s that early money that gives your retirement plan a real boost.

money makes money

In time, money makes money. People don’t realize this early on, when their savings balances are low. But those early years of saving begin to multiply in a variety of ways later on.

Here’s five ways your retirement money makes money as the years pass:

1. Interest earned

Money you set aside in a savings account, CD, money market or a bond fund is going to earn interest payments. The only questions there are the terms and the risk. A savings account or CD are lower risk and, usually, lower interest. A money market might earn you more with relatively little added risk, while a bond fund would likely pay the most but also expose you to the highest relative risk.

2. Dividend payments

A little further up the risk scale is owning dividend-paying stocks. If you buy a broad index fund of the stock market you are likely to earn dividend payments commensurate with inflation, more or less. An individual dividend stock will pay more while increasing your concentration risk. A diversified, dividend-focused fund can lower that specific risk but likely pays a bit less. In any case, as a stock holding the risks are greater than with bonds, CDs and savings accounts.

3. Tax deferral

This is a detail many people fail to consider, but any time you can defer taxes your money grows faster as a result. Using an IRA or 401(k) at work can allow you to earn more interest and dividend payments on money you would otherwise have paid in taxes while simultaneously avoiding those taxes until retirement, when your tax rate is likely to be lower.

4. Rebalancing

Investors like to say they buy low and sell high. But do they do so regularly? One way to automate this best practice is to rebalance. By setting as specific weight of say, stocks to bonds, you can reset you portfolio periodically to regain the right mix as a percentage. That way, you automatically sell gainers and use the proceeds to buy the relative “losers” in your portfolio. That adds up to real gains over time.

5. Compounding

Finally, the power of compounding takes small dollars and makes them ever larger with the years. A market rate of return is likely to double your money in 10 years or less as those dividend and interest payments are reinvested, and there’s price appreciation, too. Compounding simply means that the new total doubles again, that is, two becomes four, the four becomes eight, and eight turns into 16, etc. It’s how long-term investors retire, by saving early and letting compounding create real wealth.

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