Thursday, April 17, 2008

Wanna be a millionaire? Here's how!

The One-Year $1 Million Challenge

The One-Year $1 Million Challenge

At a certain age, if you:

Max out your 401(k) contributions for one year,
Max out your IRA for that same year, and
Merely meet the market's historical 10% annual returns

... you'll wind up a millionaire by the time you hit retirement.

More from The Motley Fool:

• Why You Must Invest Now

• The One Gotta-Have Retirement Investment

• How to Make Money in a Flat Market

That age? Twenty-six. In 41 years of compounding at 10% annually, $20,500 ($15,500 in a 401(k) and $5,000 in an IRA) will turn into $1 million. And you'll never have to contribute another dime. Of course, inflation between now and then means that $1 million won't buy nearly as much four decades in the future as it does today. Still, it's a remarkable feat of compounding.

In fact, that's how you win the $1 million one-year challenge: You make time your biggest ally in amassing phenomenal sums of wealth.

You See the Absurdity Here, Right?

In order for most 26-year-olds to save $20,500 in a single year, they'd either need to find a fabulously high-paying job or a rent-free room in their parents' basement. Either way, they'd probably be living on a strict diet of ramen noodles.

It's a stretch goal for people just starting out in life, to say the least.

But here's some good news for those of us who long ago celebrated a 26th birthday: The power of compounding doesn't care whether you invest it all at once, or only save a bit at a time.

It's most important to simply sock away as much as you can, as quickly as you can, and let it compound for as long as possible.

If You're Past 26 ...

While time is the ally of the young investor, we more mature folks haven't been entirely left out to dry. In fact, even if you're around 50 and haven't yet saved a dime for your retirement, it's still possible for you to retire with $1 million at the reasonable age of 67.

This table shows how much more effort it takes to become a millionaire when you wait longer to start saving:

Starting Age First Year's Contribution Grows to ... Consecutive Contribution Years to Reach $1 Million
26 $1,020,596 1
32 $576,100 2
36 $393,484 3
39 $295,630 4
41 $244,323 5
42 $222,111 6
44 $183,563 7
45 $166,876 8
47 $137,914 9
48 $125,376 10
49 $113,978 11
50 $133,943 12
51 $121,767 15
52 $110,697 DNF*
These calculations assume you max out your contributions every year -- including catch-ups for ages 50 and up. Does not include any employer contributions. *DNF: Does not finish with $1 million or more by age 67.

The older you get, the clearer the picture becomes: You cannot retire a millionaire from one year's savings. You'll need to be disciplined and consistent about saving, taxes, and investing.

You Can Still Get There

If you can save the cash and have the time to let compounding work, you can reach these returns. Every number in this article assumes you simply match the stock market's 10% historical annualized returns. There's no guarantee of that happening, of course. But if history is a worthy guide for the future, an easy way to match those returns is with an S&P 500-tracking index mutual fund.

The Vanguard 500 Index (VFINX), Fidelity Spartan 500 (FSMKX), or SPDRs (SPY) exchange-traded fund are three vehicles that have low costs and broad diversification.

Use Everything You've Got

Of course, the toughest part of this plan is coming up with the $20,500 per year ($26,500 if you're 50 or older) it takes to max out both your 401(k) and an IRA. It's quite a sacrifice, but fortunately, you don't have to make it on your own. Depending on your specific circumstances and the plans you have available, you'll get some combination of:

Tax-deductible contributions,
Tax-deferred (or potentially tax-free) growth, and/or
Employer-matching funds

... to significantly soften the blow to your pocketbook.

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