Every year, families and friends celebrate students who are graduating from college. Parents beam with pride at their children’s accomplishments and exhale in relief now that the tuition bills have finally stopped. It’s a time when college graduates enter the workforce, and their parents, with college out of the way, can focus on saving for retirement.
Albert Einstein purportedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Compounding is the process by which the value of an investment increases over time as earnings or interest are reinvested. It’s the snowball effect but with money. Here’s an example:
If you’re lucky enough to have up to $35,000 left over in your child’s 529 college savings plan, you can roll it over into a Roth IRA in your child’s name starting in 2024, provided the 529 account has been open for at least 15 years.1 If that $35,000 is not touched for 50 years, and the market averages a 10% annualized return, which is close to its long-term historical average, guess how much your (adult) child will have?2
A. $1,584,074
B. $2,551,167
C. $4,108,680
The answer is C. Over $4.1 million!
If your recent college grad were to start this at age 25 and invest that same initial amount for only 45 years, they would end up with B, or $2.6 million. That’s great, but not as great as C.
If you invest $35,000 for your retirement, in 40 years you’ll end up with A, or $1.6 million. Also good, but, you know, not C.
Another benefit of compounding is that it can help you pursue financial goals along the way, like making a down payment on a home, even if the entire college fund is depleted. It’s really never too early to start saving—ideally, get in the habit of adding to your portfolio every year, whether through a 401(k) or from annual cash surpluses. As you can see, having enough time for the snowball effect can help make up for not having a lot of money.
In addition to increasing the value of your investments, compounding can also be a valuable force in life. For example, a college degree has an enormous effect on the rest of your life. How much money are we talking about? College graduates, on average, earn 84% more than those with a high-school education. This wage premium adds up to an extra $1.2 million over a lifetime.3
But it’s more than just money. You are also the result of the compounding of your life’s decisions, both good and bad. It’s hard to quantify exactly, but it’s sure there. Life is full of surprises, and many of them come from how your decisions compound over decades.
So, start rolling your snowball, both in life and in investing. Let the compounding commence!
This article was loosely adapted from “Let the Compounding Commence!” By David Booth, Chairman and Founder, Dimensional, May 17, 2023
Footnotes
- Laura Saunders, “Your Child Picked a College! Tee Up Your 529 Plan,” Wall Street Journal, May 5, 2023.
- In US dollars. Based on S&P 500 Index annual returns, 1926–2022. S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
- “How Does a College Degree Improve Graduates’ Employment and Earnings Potential?” Association of Public and Land-Grant Universities.
Disclosures
The investment approach discussed does not assure a positive return or a positive investment experience. There are numerous ways of approaching investing, only one of which is presented here, which may not be appropriate for every individual.
529 Plans are tax-advantaged savings plans available in the United States that are designed to help pay for education.
The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable, and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, a recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is appropriate for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.
