The financial planning strategies of compounding and tax-deferred investing can help high school and college students use earnings from summer jobs and other seasonal employment to build a sizable retirement nest egg.
“Start small, but start now,” urge financial literacy advocates from the University of Connecticut or UCONN, who explain that young investors, with lots of time on their side, benefit most from the “magic of compounding.” (Saving for retirement ranks at the top of financial planning strategies Millionaires recommend to beginning investors.)
Compounding refers the practice of reinvesting earnings to generate additional gains at an accelerated rate. According to the experts at UCONN, an initial $1,000 investment, compounding at the rate of 4 percent per year, would be worth $3,243 in 30 years. An 8 percent rate of return would yield $10,063 after 30 years, while a 10 percent return would yield $17,449, though taxes on investment gains can reduce yields.
If that sounds like meager retirement savings, consider the following example from UCONN: An investor who puts $1,000 into a tax-deferred retirement account every year from the age of 20 through the age of 30 – a total of 11 years –will have $168,514 at age 65, assuming the account earns 7 percent each year. Tax-deferred retirement accounts boost the power of compounding because they shelter investment gains from taxes until the funds are withdrawn.
Americans receiving “taxable compensation” are eligible to open tax-sheltered retirement accounts known as individual retirement accounts or IRAs, one of the most popular financial planning strategies for building a nest egg. Even students earning a few thousand dollars a year can begin saving for retirement, benefitting from decades of tax-deferred compounding of investment gains. (The top financial fears and regrets expressed by investors relate to a lack of financial planning strategies for retirement.)
Taxable compensation includes wages, salaries, tips, professional fees, commissions, bonuses and income from a trade or business, according to the Internal Revenue Service or IRS. Contributions made to an IRA may be fully or partially deductible, depending on the type of IRA used and on a worker’s individual circumstances, according to the IRS.
Workers are allowed to contribute up to $5,000 to an IRA until they reach the age of 50, according to IRS rules. Thereafter, workers are allowed a catch up contribution of up to $6,000 a year. Workers earning less than $5,000 a year may contribute up to the amount of their earnings. As an example, the IRS gives us “Danny,” an unmarried college student working part time. He earns $3,500 and his IRA contribution is limited to $3,500, the amount of his compensation.