Good Monday Morning Financial Highway Readers! I hope you all had a nice weekend. Today we are starting a new Investing Series on Green Panda called Retirement Planning for Young 20 Something Investors. We are going to start our week off on the right financial foot by discussing our financial futures. Retirement Planning 101 tells us that investing for our retirement is for the long term. One of the benefits of investing for the long term is the compound interest effect.
What is the Compound Effect?
In a nutshell the Compound Effect is the benefit of earning interest on interest. Whether we are earning our rate of return as interest, dividends, or capital gains as long as we allow them to be reinvested in the investment account, we will benefit from the compound effect.
If we invest $1000, and we earn $50 of interest on our investment the first year, and we let the $50 of interest reinvest with our original investment of $1000 we will earn interest on $1050 in the second year. This is the benefit of the Compound Effect; we will continue to earn interest on our compounded (reinvested) interest every year. The Compound Effect allows are money to grow faster over the long term.
How does the Compound Effect Grow Our Money?
Let’s use the same example as above, let’s say that we invest $1000 at an interest rate of 5% for 25 years. If we have our interest paid out to us every year we will receive the exact same amount of $50 interest each year, because our 5% interest will always be calculated on our original investment of $1000. This will give us a total amount of $1250 in interest for the 25 years. Without the compound effect our original investment of $1000 will be worth $2250 in 25 years.
If we allow the 5% interest to reinvest every year and we take advantage of the benefit of the Compound Effect our original investment of $1000 will be worth $3386 in 25 years. Allowing our interest, dividends, or capital gains to reinvest over the years is definitely beneficial for our investment growth. The Compound Effect is definitely a beneficial investment strategy that all young investors should take advantage of.
Does the Compound Effect Affect My Taxes?
The Compound Effect does not affect our annual personal income tax return. Whether we choose to have our investment returns (interest, dividends, or capital gains) paid out to us, or whether we choose to reinvest our returns and allow them compound, we will still receive a tax slip at the end of the year. Whether or not we allow our investment returns to compound we will always have to pay tax on any investment gains at the end of the year.
Most investments such as Guaranteed Investment Certificates (GICs) as well as Mutual Fund Investment Accounts always suggest that we allow our investment returns to compound. If we want our investment gains paid out on a monthly, quarterly, or annual basis we will have to specify our investment instructions to our financial institution. The default for interest, dividend investing, and capital gains is usually to allow them to reinvest and take advantage of the compound effect.