Compounding is a term that describes when money grows on top of itself. Over a long period – like the 30 or 40 years that your money could sit in a 401k account waiting for your retirement – the compound growth is a big part of turning a little bit of money into a lot of money. When you save in a 401k, the rate at which your money compounds depends on the investments you choose.
A 401k account is an arrangement that your employer sets up to help you save at work. In and of itself, the 401k account doesn't actually save money for you, so it doesn't compound. The money that you put into your 401k has to be invested in something. The different types of investments in your 401k will determine how often your growth compounds. Some might compound daily, but some won't compound at all if you don't reinvest the growth that they offer.
Compounding and You
Compounding means that you keep earning interest or growth on the interest or growth you've already earned. If you have $2,000 in your 401k account and it grows by 8 percent, you end up with $2,160. If you just got 8 percent on the same $2,000 in the second year, you'd get another $160, giving you $2,320. However, if your account compounds, the entire $2,160 would grow at 8 percent, leaving you with $2,332.80. That extra $12.80 might not seem like a lot, but it adds up quickly. At 8 percent noncompounded, your money doubles in 12.5 years. With yearly compounding, it doubles after nine years.
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Yearly vs. Monthly vs. Daily
The more often an investment compounds, the faster it grows. For instance, if you have $1,000 invested at 6 percent and it compounds yearly, you'll have $1,060 after one year and $1,123.60 after two. If it compounds monthly, you get .5 percent interest each month. After the first month, you have $1,005, and after the second month, you have $1,010.03. After a year, you end up with $1,061.68, and after two years, you end up with $1,127.16. Daily compounding turns a 6 percent yearly return into a 6.18 percent return, giving you $1,061.83 after a year. Over a 30-year period, that $1,000 would grow to either $5,743.49, $6,022.58 or $6,048.75, depending on whether the 6 percent return was compounded yearly, monthly or daily.
Growth in a 401k depends on what you buy. If your 401k holds funds in stocks that don't pay dividends, no cash is coming out to compound even if the shares keep growing in value. When cash from your investments goes into your 401k account, that cash has to be reinvested into something for you to enjoy the benefits of compounding. Otherwise, you could have a bond fund paying you 5 percent, then have the interest sitting in a cash account, uninvested and not earning. The best way to ensure you are getting all of your compound growth is to talk to your plan administrator and see how your investment's returns are reinvested.
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