Albert Einstein was once purported to have said that compounding interest is “The most powerful force in the universe.” While the statement was likely intended to be facetious, it is a powerful force nonetheless. The power of compounding is significant. Compounding is the principle of earning a rate of return on your prior rate of return, as well as on your initial investment. This principle refers to dividends, interest and capital appreciation. This is also known more simply, as “making your money work for you.”
So just how powerful is this force in reality? In order to determine this, let’s assume two possible scenarios.
Investor A:
Begins investing at age 18 with $1,000.00 as an initial investment. Every year, for a period of 15 years, Investor A adds $100 per month to his investments while earning an average return of 7% per year. At the end of 15 years, Investor A is 33 years old and has accumulated $34,045.41. Investor A chooses at this point, to no longer contribute to his investments. Rather Investor A has chosen to let his current investment balance grow at the 7% average investment return for 32 years until they are 65 years old. Investor A, at age 65, has accumulated $296,714.97.
Investor B:
Begins investing at age 33 starts with an initial investment of $2,000.00 (2x the amount of investment that Investor A started with.) He contributes $100.00 monthly (the same amount as Investor A) until age 65, which is 32 years (So, 17 years of contributions beyond what Investor A chose to do). Investor B also earns an 8% average return for the 32 year duration of time (1% more than investor A). At age 65, Investor B has accumulated $191,427.46.
Results
What we see is that Investor A has made total contributions of $19,000 while Investor B has made total contributions of $40,400. Simultaneously, Investor A has earned a full 1% less than Investor B on investments purchased. Yet, Investor A has managed to accumulate an additional $105,287.51 more by the age of 65.
Novice investors may find this shocking. However, it is simply the power of compounding growth. This is so powerful, that a smaller investment with a lower return can outperform when time is on your side. The first lesson learned here is to note the importance of investing early in life while time is on your side.
Another factor to consider is the power of tax deferred growth which serves to amplify these numbers. As many of us realize, investments can, and will be, taxed as we earn interest, dividends and realize gains. While the above numbers are relevant, taxing these earnings during periods of growth will only erode the net figure. This speaks to the importance of utilizing tax shelters such as employer retirement plans (401ks, 403bs, etc.), as well as individual IRA’s as the first tool in order to save for retirement more efficiently.
In Summary
It should be prudent for every investor to begin a retirement strategy as soon as possible. In the case of many younger workers, they believe they don’t have enough money to make even a small investment for their future. While all of us have been young, more often than not, this is not really the case. We all tend to have some degree of waste in our spending habits to a certain extent. As financial planners we often stress to clients that the first bill you pay is to yourself. This is especially true in the case of younger people. Even if it is as little as a $50 monthly contribution into a diversified mutual fund, the sooner one creates good investing habits, the better future you will have. Many young investors believe retirement is too far off to worry about. As the above figures show, investing early is an important head start and may lead to an earlier retirement. Additionally, as older Americans have come to realize, time really does go by quickly. The earlier one starts to invest in the future, the more secure one will be as retirement gets closer.
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Self-employed investors, understand more than anyone, the importance of a return on their investments. Self-employment offers many potential tax benefits, which can be a lure to those who choose to follow that path. While there are various tax benefits through tax deductions, a small-business retirement plan is often overlooked.
Maximizing these benefits for those that have the free cash flow can be a major advantage of self-employment. In order to better understand the options available, we’ll divide these plans into two separate categories, Defined Contribution & Defined Benefit plans.
Defined Contribution Plans
A Defined Contribution plan is a plan that has a specific formula for contribution based on one’s self-employment wages. The first plan we’ll look at is the Simple IRA.
The Simple IRA
This plan is designed for an employer who has fewer than 100 employees, and those employees earn more than $5,000, and would like to establish a plan for the employer as well as their employees with very little overhead expenses. The benefit of the Simple IRA is that since it is an IRA, there are typically very little or no administrative costs. The plan allows you to contribute on your own behalf with only a small obligation to match your employees who are vested after a certain duration of having being employed within that organization. The negative aspect is the maximum dollar contribution for the owner is substantially lower than other plan options.
For 2015 the employer can contribute 100% of their compensation up to $12,500.00 or $15,500.00 for those over age 50. For each employee, the employer can choose to make either a 3% matching contribution or a 2% non-elective contribution, regardless of whether the employee chooses to participate in the plan. Once funds are contributed to a Simple plan on behalf of the employee that is eligible, the employee is immediately vested and the employee may take the funds with them when they leave. The plan must be in existence for at least 2 years before the assets can be rolled to an individual IRA upon the employee or owner leaving the business.
The SEP IRA
This plan is also an IRA with little or no administrative expenses. With a SEP IRA the contribution limits are much higher at 25% of the individuals adjusted gross income to a maximum of $53,000.00 for the year 2015. Each employee of the company, or any affiliated companies, must receive the same percentage in contributions as the employer. The employee is fully vested upon funding and cannot make their own separate contribution, as all funding comes from the employer. However, the employer can set up eligibility parameters that apply only to full time employees. They can be as stringent as three years of employment and having achieved at least the age of 21. Generally the SEP IRA is utilized for an owner and or family members in a business that does not have long-term employees, or any employees at all. The reason for this is the burden of the contribution is heavy on the employer.
The Self Employed 401k
This plan is not an IRA, but a qualified retirement plan under the Employee Retirement Income Savings Act (ERISA). It allows for a maximum of 100% of salary deductions up to $18,000.00 for 2015 (An additional $6,000 for those over age 55). Furthermore, beyond the salaried contribution, the owner can make a profit sharing contribution of another 25% of compensation up to a combined amount of $53,000.00 for the year 2015 ($59,000 for those over age 50). This plan has largely replaced the old money purchase and individual profit sharing Keogh plans of the past with its hybrid approach to contributions. One specific requirement is the plan is only available to self-employed individuals and their immediate families. If there is a non-owner working for the business, the employee may not contribute to this plan and must utilize a different option. One other key component is the reporting is a bit more complex. Once the plan assets reach $250,000.00, the participant is required to have the IRS form 5500 completed each year. This notifies the IRS of not just contributions, but plan balances as well. This plan also exists in a ROTH version which offers the tax-free growth, without the tax deductions. Much like the SEP IRA, this would not be utilized for an individual with employees.
Defined Benefit Plans
When it comes to individuals with substantial resources who wish to make contributions beyond that of the options referenced above, there are various options. A defined contribution can be in addition to one of the plans mentioned above. This type of plan establishes a future annual benefit in retirement. The annual contribution is typically the actuarial value of what is required to meet that benefit. Meaning if you are 60 and plan to retire at 65, the amount of the contribution will be substantial if you just started the plan. Most typically a defined benefit is simply a pension plan. The maximum contribution in 2015 is the actuarial value of $210,000.00. It is important to note that these plans have additional benefits testing that must be done to accommodate employees based on income and age. There are various versions of these types of plans, and depending on the demographics of your staff, the employer would want to have an independent actuary help create the plan design to ensure employees receive the maximum benefit and remain in compliance. The start-up administrative expenses can be as high as $5,000.00 with an annual expense of around $1,500.00 per year for annual filings and plan amendments. It should be noted that although an employer has an annual benefit to be calculated, typically the plan is just closed and the lump sum commuted value is rolled to an IRA in retirement.
Cash Balance Plans are another option and is somewhat of a hybrid, in that this plan is defined not an annual benefit in retirement, but rather a future closing value of the plan balance in retirement. This also requires the assistance of an actuary for plan design. This plan, can in certain circumstances, favor a more equitable distribution of funding for business partners that have a varying age range. There are once again benefits testing requirements that must be completed.
Non-Qualified Deferred Compensation plans are another option that can be built in addition to the other two. These can be a bit more restrictive for employees holding certain positions within the company, and may encompass for example, only VP’s of the organization. Once again there are many versions of these plans that need to be structured quite precisely. However, one major risk within a Non-Qualified Deferred Compensation plan is, unlike a Defined Benefit or a Defined Contribution plan where the assets in the account belong to the participant, here they are an asset of the company. So in the event of the business being dragged into litigation or a bankruptcy, the plan assets are usually subject to claims by the creditors.
When selecting which plan makes the most sense, one should be consulting not only their financial planner, but also a tax advisor. Should you choose a dual plan option because of the excess taxable income at your disposal, it is wise to seek an independent actuary who serves as a third party administrator specializing in plan design. Many insurance companies can provide this type of plan with actuarial services at a reduced administrative expense. However, in return there are usually very costly investment solutions with hidden fees that make the plan far more expensive versus designing them independently.
Plan selection is relatively simple when a small business begins. However, as a business grows and increases free cash flow, plan design can become much more complex when attempting to balance maximum tax benefits in contrast to the employers out of pocket cost.
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