February 11, 2010

Christopher J. Thomas, a 29-year-old customer service representative, will likely be a millionaire by the time he’s 40 — and it has nothing to do with being a high-flying businessman. It’s all about being frugal enough to save big and early. That allows time to work magic on his portfolio.

"Two years ago, I’d go shopping anytime I was bored. I stopped doing that, and it’s making me way more financially free," Thomas said. "It was a game-changer."

Thomas was lucky enough to discover what many people learn when it’s too late: Making small sacrifices when you’re young can make you rich before you know it. That’s all because of what Albert Einstein reportedly called "the most powerful force in the universe"— compound interest.

Compound interest is a simple concept that works like this: If you deposit \$100 in a bank account earning 5 percent interest, you earn \$5 by the end of the year. If you leave the money in the account for another year, you earn 5 percent on \$105, or \$5.25, which boosts the balance of your account to \$110.25. (And, yes, we know you couldn’t get a 5 percent return from a bank right now. The example just works better with round numbers.)

That’s no big deal over short stretches, but over long periods of time, the interest you earn on your interest can knock your socks off. Consider, for example, Steve Steady, a hypothetical saver who simply decided to sock away about \$6.50 a day (\$200 a month) from the time he was 20.

At age 21, his nest egg (assuming an 8 percent average annual return compounded monthly) is worth \$2,491. At age 22, he’s got \$5,188 invested. That’s no fortune, to be sure, but it’s not too shabby either.

Steve starts to gain some traction by age 30, when that \$200 a month has now built up to a tidy \$36,591. And now, compounding really starts to work its magic. At age 40, he’s got \$117,809; his money more than doubles by age 50. And by the time he wants to retire at age 65, his nest egg is worth more than \$1 million (\$1,054,944, to be precise).

What’s even more remarkable is that Steady has only contributed \$108,000 of his own money. The remaining \$900,000 million came from interest compounding on interest.

 Is it reasonable to think that Steady will earn average 8 percent on his money?Assuming he’s investing for the long haul, in a broad array of stocks such as through a low-cost index mutual fund or Exchange Trade Fund, yes (though, of course, nothing is certain when it comes to investing). According to Ibbotson Associates, a market research firm, big company stocks have returned an average of 9.8 percent since 1926 — a stretch that included the Great Depression and last year’s market debacle that sent prices plunging some 37 percent.If you invest in a mix of big and small companies (such as Vanguard’s Total Market Index fund or Vanguard’s Total Market ETF), you’re likely to do slightly better. Small company stocks have earned more than 11 percent on average annually over the past 84 years.

What Thomas decided to do was even smarter than the hypothetical Steady, although he didn’t start when he was 20.

A couple of years ago, he and his wife opted to live small so that they could save really big. Instead of buying new (or lightly used) cars every few years, he paid cash for a 1993 Cadillac, eliminating his car payment. He also gave up shopping. Even though he usually just bought t-shirts and lunches when he went on weekend shopping sprees, he realized that forgoing the mall saved hundreds of dollars a month. Altogether, he and his wife are saving \$26,500 a year – about a third of the couple’s income.

He took that savings and started contributing the maximum amount possible to his 401(k), a tax-favored savings account that his employer offered through work. The money comes out of his paycheck before he gets it (and is tempted to spend it)—and before taxes are computed on his salary. Both Thomas and Uncle Sam act as if he never earned the money.

Because of the tax benefits of these accounts, each \$100 Thomas contributes costs him only about \$70 (assuming he pays about 30 percent of his income in federal and state taxes). Better yet, his employer matches 100 cents on every dollar.

Thomas puts in \$16,500 per year, or roughly \$1,375 per month. His company does the same. That means the \$16,500 he saves (which costs him only about \$11,550 in after-tax spending), becomes \$33,000 after the employer match. Plus, he and his wife put \$10,000 a year into Roth IRAs,

which are another type of tax-favored savings account.

Right now, Thomas has \$118,000 in his 401(k). (And he and his wife have got another \$62,000 socked away in emergency savings and Roth IRAs.) If they keep saving at today’s rate, and his employer keeps matching, they’ll have more than \$200,000 29 by the time Thomas is 30, and a tidy \$1,187,206 by the time he turns 40.

If they stick with this program and they’re able to earn about 8 percent annually on their money, they’ll have more than \$12 million by the time they’re ready to retire, which could make their golden years pretty darn gilded. (That’s particularly nice since most people in Thomas’ generation figure they’re more likely to get Christmas gifts from Martians than collect monthly checks from Social Security when they retire.)

But what if he can’t save like that forever? What if, for example, he has to stop saving when he’s 40 because now he’s got kids to send to college and other big obligations and simply can’t afford any savings at all?

Because he did so much so young, he’ll still be rich when he’s older. If Thomas never socks away another penny after the age of 40 but keeps earning 8 percent on his money, he’ll still have \$8.7 million when he retires.

What if he can’t make 8 percent? Even if he only makes 5 percent a year, if Thomas keeps saving at his current pace until he’s 40,he’ll have \$3.3 million at 65, and his contributions will account for just one-fifth of that amount. The rest will be the result of compound interest.

On the other hand, it he waits until 40 to begin saving, and earns 5 percent on his money, he’ll end up with just over \$2 million at retirement, of which half would be money he put in. You just can’t beat saving big early in life.

"People ask me if there’s one thing you can do to fix your financial life and this would be it," he says. “You just start contributing as much as you can to your 401(k). It really adds up, and it’s not that hard to do."

In fact, says Thomas, it’s fun.

"When you see how much your balance is building, it gets really addicting."

Want to see what your savings could be worth? Use this Calculator to estimate how much you’ll have by your planned retirement date if you start saving now.