The power of continuous contributions and compounding

Some retirement vehicles, such as Traditional IRAs and 401(k) plans, allow investments to grow federal income tax deferred. Others, such as Roth IRAs, allow them to grow federal tax free. In either case, there is no income tax on the money one invests or on the growth of that money while it's in the account. A distribution from a Roth IRA is tax free and penalty free provided the 5-year aging requirement has been satisfied and one of the following conditions is met: age 59½, death, disability, qualified first time home purchase.

You can reinvest any gains on your retirement plan assets, and get the potential benefits of compounding, for as long as that money is kept in the accounts.

The snowball effect of compounding can be quite powerful, since if you have gains on your initial principal, you may then start making gains on the gains and so on and so on. As an example, an initial principal of say $100 with a 10% annual return per year would be worth $110 after the first year, $121 the second year, $133.10 the third year, $146.41 the fourth year, and so on. This is, of course, a hypothetical situation and assumes a steady 10% return per year, which is not a likely scenario for any investor.

The snowball effect of compounding makes early investing, particularly in a retirement account due to the tax benefits, that much more enticing since the earlier you start investing, the more compounded returns you can hope to make. Additionally, the more you contribute to your retirement plan, the better; try to contribute the maximum amount each year so your principal may generate the most return possible.

For 401(k) plans, the employee contribution limit is $23,000 for 2024, with an additional $7,500 catch-up contribution allowed for employees age 50 or older. For IRA plans, the 2024 contribution maximum is $7,000. For those age 50 and over, the IRS allows an additional $1,000 catch up contribution. As long as you turn 50 during any day in the year, you are eligible for the catch-up contribution.

The benefits of compounding and tax-deferred growth are worth the efforts of early and continuous saving. To put all of this into context, let's say Julie starts contributing the maximum $7,000 IRA contribution at age 25 and keeps at it all the way through retirement at age 70. With annual compounding, she would have amassed $2,345,576 by 70. Compare this number to that of Julie’s friend Amy who didn’t start contributing the $7,000 max to her IRA until the age of 35. She only amassed $1,163,368. For simplicity's sake, we are not calculating the catch-up allowance of an extra $1,000 once Julie or Amy hit 50. We are also assuming a hypothetical and steady 7% return per year, and we are not taking any taxes, fees, or inflation into account. As with before, this is not a likely scenario for any investor, but helps to demonstrate the point.

This hypothetical example assumes the following (1) annual IRA contributions on January 1 of each year starting in 2024 for the age ranges shown, (2) maximum annual IRA contributions are $7,000 in all years beginning in the first year, (3) for ages 15-20 a $3,000 contribution and from 21-50 a $7,000 contribution, (4) an additional $1,000 catch-up contribution for each year in which the investor is age 50 or older by December 31 of the year for which the contribution is made, (5) an annual rate of return of 7% and (6) no taxes on any earnings within the IRA. The ending values do not reflect taxes, fees or inflation. If they did, amounts would be lower. Earnings and pre-tax (deductible) contributions from Traditional IRAs are subject to taxes when withdrawn. Earnings distributed from Roth IRAs are income tax free provided certain requirements are met. IRA distributions before age 59 1/2 may also be subject to a 10% penalty. Systematic investing does not ensure a profit and does not protect against loss in a declining market. This example is for illustrative purposes only and does not represent the performance of any security. Consider your current and anticipated investment horizon when making an investment decision, as the illustration may not reflect this. The assumed rate of return used in this example is not guaranteed. Investments that have potential for a 7% annual rate of return also come with risk of loss. This hypothetical does not reflect the impact that minimum required distributions from a Traditional IRA could have if you turn 73 during the time period.
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Article copyright 2012 by Ali Velshi and Christine Romans. Reprinted and adapted from How to Speak Money: The Language and Knowledge You Need Now with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.

There is no single Disclosure Text associated with this entry. See Overview of Use above for the hyperlink to the disclosures for hypothetical retirement investing illustrations.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.