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Welcome to the very first Money Crunching Mondays post!
In this series I will run the the money crunching math of different personal finance scenarios. While the math is simple, the results are often enlightening.
This week I break down the math behind just how much money you can save if you were to put aside $50 every month.
Save $50/month for 5 years
- Monthly contribution: $50
- Annual contribution: $600
First we will look at how much you can acquire over 5 years of this savings habit. I’ll run the numbers under two different assumptions:
- Money is saved in an online high interest savings account, earning an average of 2% interest, compounded monthly.
- Money is invested in a total market ETF through a Vanguard traditional IRA, earning an average of 7% interest, compounded monthly to make things easy. How did I arrive at 7%? This is the average rate of return since inception.
Scenario #1: 5 years
The first step in crunching the numbers is to keep it simple. Run a Google search for a “compounding interest calculator”. I used one from Bankrate.
Here are the numbers for 5 years of savings in an online savings account.
As you can see, over the course of 5 years, you will have saved $3,000, however you will also have earned $158 in interest. That’s an additional 5.2% in overall investment earnings.
Interest earnings = (Total at end of investment – Total contributed) / Total contributed
The resulting number is then multiplied by 100 to give us a percentage.
Scenario #2: 5 years
Now let’s see what happens if we instead invest that $50/month.
While there are a vast number of ways one could invest this money, I’m going to assume that it is for long term savings and therefore placed in a tax-advantaged traditional IRA, earning an average 7% rate of return. I’m also assuming that funds are invested in a low cost ETF fund, such as Vanguard’s VTSAX fund, so I won’t factor in any management expenses.
After 5 years, here’s what the numbers look like:
With the higher rate of return we now have an extra $443 in savings after 5 years.
Save $50/month over 10 years
So far we have learned that by saving $50/month for 5 years you have a total of $3,158 – $3,601. It is clear that the higher interest account leads to increased savings, a full 20% increase in savings for the investment account.
Scenario #1: 10 years
So after a full 10 years of saving an extra $50 every month and placing that money in an online savings account, we have a total savings of around $6,650. Interest earnings now account for an additional 10.8% savings.
Scenario #2: 10 years
After 10 years of stashing away $50 per month and placing it in the stock market, we now see compounding interest taking effect. While there was only $600 in interest earnings after 5 years, by 10 years we’ve more than tripled that. The total interest earning account for an additional 45% of what was invested.
Remember, there was only a 10% increase in savings from the online savings account.
Save $50/month for 20 years
If you can manage to stash away $50 every month for 10 whole years, what’s another 10 years? Let’s look at what happens when we keep saving for a full 20 year time span.
Scenario #1: 20 years
If you keep adding funds to a high interest savings account, at the end of 20 years you will have saved a full $12,000. Compounding interest earnings add an additional 23% to that total, providing a nice emergency fund of $14,700.
Scenario #2: 20 years
Now the numbers are getting interesting! Compounding interest has had time to really kick in for our investment account. After 20 years you have still saved a total of $12,000. But now an additional 118% is added to our savings, simply from interest earnings. That’s more than double!
Here are the numbers by year for both the savings and investment account scenarios.
Can you invest with just $50 a month?
We can take this further and see just what impact investing just $50 a month can have on your retirement savings. Assuming a 7% rate of return, your balance after 30 years is $61,350. After 40 years? #132,000.
Now lets assume an 8% rate of return. After 40 years you now have $175,700. The interest earning alone account for $151,700. Your only contribution was $24,000. But instead you have over $150,000.
Even if you can only save a little, that little bit will grow over the years and result in a significant contribution to your retirement savings. Which means an earlier or more comfortable retirement later on.
Discussion
What exactly can we learn from running through these savings projections?
- Compounding interest takes time to build momentum. The longer you save, the greater the effect.
- Every little added interest percentage matters. The difference between interest earnings over 20 years for a 2% account and a 7% account is 95% of extra money. It pays to put long term savings in an investment account rather than a mutual fund or savings account.
- Every little bit saved can make an impact over time. If you think about it, $50 a month of extra savings is not much. It’s the difference of giving up your ESPN cable package, resisting the Starbucks latte a few days a week or driving less and saving an extra tank of gas. It isn’t difficult to find ways to save this much extra, but over time it can amount to a significant stash of interest earning cash.
- Can you invest with just $50 a month? Absolutely. In fact, it can and will kickstart your retirement.
A note on tax advantaged retirement accounts
Scenario #1 involves contributing after-tax money to a savings account. This money is considered liquid, meaning you can access it within a few days and use it for emergency expenses or a downpayment on a new home. But it’s important to remember that you already paid 20-45% taxes on your income in order to save that $50. It takes more earned money to save the $50.
Additionally, you now have to pay taxes on all your earned interest. At the end of every year, whatever interest you have (as seen in the savings balance table), you pay income tax on. So if you are in a 25% tax bracket and you earn $100 interest, you really only have $75 of extra savings.
However, if you invest your $50 savings in a tax-advantage retirement account, such as a traditional IRA, you don’t pay taxes on that money before investing it. You are truly investing $50 of earned income. Even better, the earnings on your investment (compounding interest) are also growing tax free.
Essentially, what you see is what you get. The only time you pay taxes is when you withdraw money after 60.5 years of age. Even then, there are ways (legal ways) to transfer funds to a post tax ROTH IRA (ROTH conversion ladder) and withdraw funds tax free.
In other words, you pay taxes as you withdraw later in life, but those taxes will ;likely be lower than your current tax rate and there are creative ways to minimize the impact.
All in all, it pays to invest in your long-term tax-advantaged account, even if you only have a little extra to stash away.
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