Eighth wonder of the world, and money.

The seven wonders of the world are glorious to look at. You want to breathe in the pyramids of Giza, you want to walk through the colosseum thinking about how good a gladiator Russel Crowe would have been, you want to hike Machu Picchu and decipher the secrets of Incas. Compounding is cheekily referred to as the eighth wonder of the world. It’s nothing like the seven. It’s boring, it’s slow, it’s long term, and you can’t tangibly see it happen while it’s very real. You could compound, let’s say your skills over time. If you have a thirst for learning skills, you might learn woodworking, then learn brick laying, learn about construction, and then learn about smart electronics. So compounding these skills over years, you could one day build your own smart home, with some help of course. The same principle could be applied to knowledge, productivity, relationships you get the gist. But what we are going talk about today is the compounding power of money.

If you combine money compounding with tax deferrals/exemptions, you get retirement accounts. IRAs or individual retirement accounts are tax deferred or tax exempt depending on the type of account.

Lets start with 401k

A 401(k) plan is a retirement savings account that’s offered by employers. Employees can contribute a portion of their paycheck to a 401(k) plan, and their contributions are typically matched by the employer. The money in a 401(k) plan grows tax-deferred, which means that you don't have to pay taxes on your earnings until you withdraw them in retirement.

Here’s a few things to remember

• As of 2023, 67% of the private industry has access to 401k plans.

• The amount you can contribute to a 401(k) plan each year is limited by the IRS. The contribution limit right now for individuals is $22,500, and the contribution limit for individuals aged 50 or older is $30,000. IRS usually increases contribution limits annually and the information is released on the IRS website.

• Your 401k plan providers could be The Vanguard Group, Merrill Lynch, Fidelity Investments, and several others. You can use these to invest in ETFs or target dated retirement funds such as target retirement 2040, 2045, 2050. The funds are a mix of stocks, bonds, and other assets and usually get more conservative as you approach your retirement age.

• Many employers offer to match a portion of their employees' 401(k) contributions. This is free money, so it's important to contribute enough to your 401(k) plan to get the full match. The average employer match is around 6% for most of the US employees. Employers may not do a 100% match in some cases. For example, if your salary is $100000 and your employer’s matching 50% contributions to 6% of your salary, you would have to contribute 12% of your salary (i.e., $12000) to receive maximum employer contribution.

• If you are free of debt (credit card debt, student loans), it’s a good idea to max out your 401k contributions to get the best of employer contributions.

• If you change employers, you can always roll over your existing 401k plan to your new employer or convert it to a traditional IRA.

• Alright, so 5 years in let’s say you want to start a side hustle or do a big stock options play. You realize you’ve got $20k sitting pretty in your retirement account, why not use it while you’re young. You have to realize, if make that early withdrawal, usually you must pay a 10% penalty plus taxes(which could be 30%) on it. Now, there are some exceptional circumstances which allow you to make early withdrawals such as disability, employer separation after age 55 or financial hardship. So, you must consider your money in 401k as effectively locked and unavailable. This is why it is usually better to maximize your 401k contributions after you’ve paid your high interest debts (such as credit cards and student loans).

• For additional resources on 401k, you can refer to the 401k page of IRS website.

  • TL;DR: 401k plans are a great way to plan for your retirement, take advantage of free money (offer in employer match by your employer) and to grow your money tax free until retirement. If your employer offers a 401k, you should subscribe to it.

Traditional IRA

This is essentially like a 401k account but it’s not managed by the employer , but the individual. The contributions are made with pre-tax dollars, the investments grow tax-deferred (which means you don’t pay taxes until you make withdrawals in retirement).

• You can have a traditional IRA whether you are covered by any other retirement plan.

• Your investments grow tax deferred. You only pay taxes on your withdrawals after the age of 59⅟₂.

• For 2023, if you are covered by a retirement plan at work, your deduction for contributions to a traditional IRA is reduced (phased out) if your adjusted gross income is:

  • More than $116,000 but less than $136,000 for a married couple filing a joint return or a qualifying surviving spouse.

  • More than $73,000 but less than $83,000 for a single individual or head of household, or

  • Less than $10,000 for a married individual filing a separate return.

• Like 401k, you must pay a 10% penalty plus taxes on withdrawals made before the age of 59⅟₂. There are some exceptions to the 10% penalty, such as:

  • Withdrawals for qualified education expenses

  • Withdrawals for qualified first-time homebuyer expenses

  • Withdrawals for medical expenses that are not covered by insurance.

  • Withdrawals due to a disability

  • Withdrawals made after the death of the IRA owner.

• You can choose your own range of investments from ETFs, target retirement funds and other assets.

• Usually, contributing to a traditional IRA is recommended only after you max out your 401k contributions.

• Detailed information on the Ira contributions, distributions, credits, and transfers can be found on the IRS website.

Roth IRA

This type of retirement account is different from the 401k or traditional IRA in that the contributions are made with post-tax dollars and the withdrawals are completely tax-free after the age of 59⅟₂.

Peter Thiel was in the news as he turned $2000 into $5 billion. He bought 1.7 million shares for his startup Paypal in 1999 for $0.001 per share, or $1,700 and put them in his Roth IRA. Paypal went public in 2002, and his Roth IRA blew up to $5 billion by the end of 2019. Of course, there was quite a bit of backlash as other billionaires would use Roth as tax haven and withdraw massive tax free wealth at 60.

Nonetheless, there are great benefits to Roth IRA -

• Your contributions are made with post-tax dollars. Hence, there is a limit of $6,500 (for year 2023) per year for an individual. IRS also increases contribution limits once every few years to match for inflation.

• Your investments grow tax-free and you can withdraw these after 59⅟₂

• The individual can invest the money in ETFs, REITs, stocks, retirement funds, bonds and some other assets and make regular buy/sell orders. However, it’s important to note that the 30 day wash sale rules also apply to Roth IRA stocks.

• You can make contributions to a Roth IRA even if you are participating in any other retirement plan.

• The adjusted gross income limits for Roth IRA contributions for 2023 are as follows:

  • Single filers: $138,000 or less

  • Married filing jointly: $218,000 or less

  • Head of household: $198,000 or less

  • Married filing separately: $0-$10,000

• A Roth IRA owner can also withdraw without penalty and taxes once up to a maximum of $10,000 in earnings, to acquire a principal residence.

• The Roth IRA 30-day limit is a rule that allows the account holder to withdraw money from your Roth IRA tax- and penalty-free if the money is deposited back into the same Roth IRA within 60 days. This rule is often used to "borrow" money from the Roth IRA for a short period of time. To qualify for the Roth IRA 30-day limit, the following requirements must be met:

  • The money must be deposited into the Roth IRA within 60 days of withdrawing it.

  • The complete amount that was withdrawn must be deposited.

  • There shouldn’t be any other outstanding loans against the Roth IRA.

Backdoor IRA

A backdoor Roth IRA is a strategy used by high-income earners to contribute to a Roth IRA, even if their income exceeds the income limits for direct Roth IRA contributions. The strategy involves making non-deductible contributions to a traditional IRA and then converting those contributions to a Roth IRA.

To qualify for a backdoor Roth IRA, you must meet the following requirements:

• You must have earned income.

• You must not be covered by a retirement plan at work (such as a 401(k)).

If you meet all these requirements, you can contribute up to $6,000 to a traditional IRA in 2023 ($7,000 if you're age 50 or older). These contributions will not be tax-deductible, but they will grow tax-free in the Roth IRA.

Once you've made your contributions, you can convert them to a Roth IRA at any time. However, it's important to note that you may have to pay taxes on the converted amount if you have any pre-tax money in your traditional IRA.

We looked at different scenarios and came up with our own sequence strategy for a young investor just out of college. Remember, we suggest following this strategy if you are relatively out of debt (no credit card debt, education loan, personal loans). If you are already in severe debt, its better to pay off those debts before making contributions to retirement accounts. While the suggested investment approach is good from our standpoint, we strongly recommend you talk to your financial advisor before making any decisions.

Retirement Planning

We recommend you start planning for your retirement as early as possible in your life to realize the benefits of compounding. Compounding shows how small investments early on can yield huge returns after a long time. The Oracle of Omaha, Warren Buffet has a current net worth of about $112 billion. However over 90% of his wealth was created over the last 30 years. His net worth in 1990 was about $14 billion.

Here is a simple calculation showing the effect of compounded returns. Suppose you start investing $500 a month at the age of 25 and continue investing till you reach the retirement age of 67. At annualized returns of 8%, you would have a large retirement corpus of $1,825,461.0 while your contributions were just $252,000.0.

Here is a small chart showing what your retirement would look like if you started investing at 500$/month at different ages of your life while expecting a compound return of 8%.

You can find a free calculator here on the investor.gov website where you can plan your time period of investing, contributions and interest rate and calculate your corpus.

While, it may not seem as worthwhile in the beginning or in the middle, compounding is as real as it gets.