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Compounding interest simply means to add any interest that you earn on an investment or account to the principal. This increases the size of the principal and the amount of interest earning money that you have. It is one of the fastest and most effective methods of building wealth known.
Many investments including IRAs, 401ks, Annuities and Universal insurance policies are designed to take advantage of compounding. In an annuity any interest you earn is added to the principal. This can increase the amount available and the number of payments that can be made from the plan. Retirement vehicles are often designed to earn compound interest.
How Compound Interest is Calculated
The usual method of compounding is to add the amount of interest that a vehicle earns in one year to the principal. If Mr. Smith put $20,000 into a deferred annuity that earned 4.5% interest a year and left it there for twenty years. He would have $48,234.28 in the plan at the end of that time.
The reason for this is that all the interest he is earning is added to the principal to increase the amount of interest each year. In the first year he would earn $900 in interest so in the second year he would be earning interest on $20,900 rather than $20,000. That means he would earn $940.50 in interest the second year. It also means that he would be earning interest on $21,840.50 in the second year. After ten years he would have $29,721.90 in the plan and earn $1337.49 in interest that year.
As you see compound interest is a win-win situation for the investor both the principal and the amount of interest you earn increase. If you want to see for yourself just take a look at this simple compound interest calculator. It verifies all the figures here.
Compound Interest and Taxes
Compound interest like all income in the United States is subject to the federal income taxes. It can also be subject to the state income taxes in some states. Yet there are tremendous tax advantages to some compound interest earning mechanisms.
Retirement plans including annuities, IRAs, 401ks and life insurance policies are tax-deferred. That means no taxes are due on the funds in one until you take them out or start receiving payments. Mr. Smith would not have to start reporting the money in his annuity until he started receiving the payments. Once he did he would only have to report the annuity payments he received on his tax returns. The principal would not be considered taxable income.
There are limits to the amount you can invest in some tax-deferred plans but there is no limit to the amount of compound interest you can earn on them. There is no limit on the amount that you can invest in an annuity or a life insurance policy. That means Mr. Smith could add funds to his deferred annuity to increase the amount of compound interest that he would earn.
It is easy to see why Albert Einstein once called compound interest the most powerful force in the universe. It is still one of the best wealth generation mechanisms around and a powerful ally when you are saving for retirement.
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