The Time Value of Money

Individuals who start saving earlier in life have an advantage over those who start later. That’s because when you put away even small amounts early, a very important financial concept is working for you: the time value of money.

When you put money away in savings or investments, the amount you save or invest is the principal. The principal earns interest, which then is added to the original principal. This amount (principal + interest) again earns interest, and so on. This process is called "compounding," and its effect is like magic when you let it work for you over time.

Here is a dramatic example of why it pays to start saving and investing early. Imagine the following scenario:

Alletta starts investing $1,000 a year at the age of 22 in a tax-deferred individual retirement account (IRA). Tax-deferred means the earnings and the principal aren’t taxed until the money is withdrawn, usually years later. Alletta quits putting money in the IRA after nine years, at age 31, but leaves her money so it will grow through compounding until she reaches retirement age.

Her twin brother, Cory, doesn’t start investing $1,000 until age 31. But once he starts, he invests $1,000 in his IRA every year for 34 years, until he reaches retirement age. Alletta and Cory both earn 9 percent annually on their IRAs. Who has the most money accumulated in their IRA for retirement at age 65? Look at the chart below—you may be surprised!




Alletta’s IRA
Cory’s IRA
Interest
rate
9%
9%
Number of years
of contributions
9
34
Age when
investing/saving
22–31
31–65
Amount
contributed
$1,000 per year for
9 years
(or $9,000)
$1,000 per year
for 34 years
(or $34,000)
Future
value
$243,863 at age 65
$196,982 at age 65