Rule of 72 Favors the Prepared Mind
- The difference between taxable and tax-deferred investments can be enormous over long periods of time.
- The Rule of 72 is a shorthand way of calculating how long it will take a saver’s (or investor’s) money to double at various rates of interest.
- The Rule of 72 can be just as important for early retirees as it is for young people just starting their careers.
- Try not to take distributions from IRAs, 401(k)s or qualified plans until age 70-1/2 so you can avoid the tax consequences.
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Are you familiar with the Rule of 72? It’s a shorthand way of calculating how long it will take for your money to double. Take an interest rate—say, 7 percent. Divide 7 into 72, and that’s a little over 10. That means it will take a little over 10 years for your money to double at a 7 percent rate of interest.
Rule of 72 in action
Suppose you have a 30-year-old willing to defer his or her money into a 401(k) over the next 30 years instead of putting it into taxable investments. At a 7 percent annual growth rate, that $100,000 is going double three times over during the next 30 years. From age 30 to 40, the money will grow from $100,000 to $200,000. From age 40 to 50, the money will grow from $200,000 to $400,000. And from 50 to 60, the money will grow from $400,000 to $800,000.
On the other hand, if our 30-year-old puts the same $100,000 into fully taxable investments, their tax rate is probably 30 to 35 percent. At the same 7 percent interest rate (pre-tax), it’s going to take the money 15 years, not 10, to double, because it’s really earning only 4.95 percent after taxes. The 30-year-old will have to wait until age 45 for that $100,000 to double to $200,000. And then it will take from age 45 to age 60 for that $200,000 to double again to $400,000.
What would you rather have after 30 years—$400,000 or $800,000? Sure, some will argue that you still have to pay taxes later on with the 401(k) strategy. That’s true. But you’d have to be in the extremely high 50 percent bracket to not come out ahead.
You’re never too old for the Rule of 72
Even if you’re 60 or older, the Rule of 72 still applies. What’s the biggest worry for retirees these days? Running out of money. If you’re age 60 and in good health, you can reasonably expect to live another 30 years. Your money will continue to compound especially if you can avoid taking early distributions from your IRAs, 401(k)s or qualified plans between the ages of 60 and 70-1/2. Sure, you’re required to start taking distributions at age 70-1/2, but why do so before and pay all those taxes?
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