How time can turn $3,000 into $50 million
Reprinted courtesy of MarketWatch.com.
To read the original article click here
As hard as it may be to believe, it’s possible to turn a single $3,000 investment into $50 million in a single lifetime. I can’t say that I have done it, but I’m going to show how you could.
This is a very tall order, one that requires an entire lifetime and more than one person to carry it out. If you’re a parent or grandparent, you can do this. Someday, a child or grandchild could be very grateful that you did.
This is the fourth column in a series on compound interest, which was famously cited by Einstein as one of the wonders of the world. For worthwhile background, you may want to read the first, second and third columns in the series.
The plan I am about to describe isn’t magic. It’s a recipe with four essential ingredients:
An initial investment of $3,000
A Roth IRA
An investment that’s likely to grow at 12% over a very long time
A long lifetime (plus ample patience).
Want to try it? Here’s how, using an imaginary infant named Brendon for the example.
When Brendon is born, set aside a lump sum of $3,000. Invest it in an ETF or a mutual fund that holds small-cap value stocks. (To learn more about this check out my podcast called The Best Small-Cap-Value ETF.)
Leave the money in that asset class to grow. And grow. As soon as Brendon has taxable earned income, start contributing the money in the account to a Roth IRA in his name, keeping it invested in small-cap value. That way, at least under current tax law, it will never be taxed. Do this every year until all the money is within a Roth account.
Assuming that Brendon leaves this money alone and that it continues to compound at 12%, when he is 65 years old, your one-time $3,000 investment in small-cap value will be worth about $4.75 million.
That is still far short of $50 million. Let’s follow the money and see how this scenario plays out.
Assume that at 65 Brendon starts withdrawing 5% of the balance of his small-cap value account every year. That first year, he takes out $237,281. (Compare that figure to your $3,000 investment.) Because the money continues to compound at 12%, his balance grows, and so do his yearly withdrawals.
When he’s 70, he’ll take out $323,572, based on his account value of $6.47 million. At 80, the account is worth slightly more than $12 million, and he takes out $601,710 — theoretically without any tax liability.
If we assume Brendon keeps this up until his death at 95 (his final annual withdrawal being $1.5 million), his account will be worth about $30.5 million. Starting at age 65, he will have taken out a total of $21.6 million. That final value plus all the withdrawals come to more than $50 million from your initial $3,000. And, presumably, very little of it will have been taxed.
So let’s ask ourselves: What’s wrong with this picture?
First, future returns of 12% aren’t assured. Not by a long shot. (That’s why this investment is best made with money that won’t be essential for Brendon’s future welfare.)
Second, by the time Brendon is a young adult he will figure out that he has a lot of money, and he will have to resist the temptation to spend it.
Third, it’s extremely unlikely that today’s tax laws will remain unchanged for the next 95 years. Congress could very well find ways to tax accumulations of wealth inside Roth IRAs.
Fourth, Brendon might someday have to relinquish half the account in a divorce.
Fifth, the elephant in the room, so to speak, is inflation. A withdrawal of $237,281 sounds like a bucket of money at age 65. But I can almost guarantee you that a dollar in the year 2080 won’t be worth the same as it is in 2015.
Assuming future inflation of 3% inflation, in today’s dollars, Brendon’s account at age 65 would be worth $694,821, and his first withdrawal would be worth $34,741. (That seems much less spectacular than the previous numbers I cited, but in real purchasing power, that single withdrawal has more than 11 times the real value of your entire $3,000 initial investment.)
At the end of his life at age 95, Brendon’s annual retirement withdrawals would total about $1.83 million, and his account would be worth about $1.84 million.
There, in “real” dollars, is the payoff: $3,000 becomes $3.6 million.
Brendon doesn’t have to do much to achieve this result, except for probably paying some taxes along the way. Presumably he will have discretionary income to invest in his own retirement account. That plus (if he is lucky) Social Security and other savings may meet most of his retirement needs.
That means the small-cap value account may be available to him for “extras.” And it also provides a very generous pool of money ($1.84 million in today’s dollars) for him to leave to his heirs.
Starting with $3,000 when Brendon is born isn’t the only way to achieve results like this.
You could invest $365 a year for the first 21 years of Brendon’s life.
You could invest $365 a year until Brendon is 21 and rely on him to continue that until he’s 64.
You could make an initial investment of $3,600 when Brendon is 21 and then count on either you or Brendon to continue adding $3,600 every year until he’s 64.
Or you could wait until he’s 25, invest $5,500, then count on him to add that same amount every year until he’s 64.
In each of those scenarios, the total of withdrawals plus ending values come out about the same, ranging from $52 million to $59 million.
However you do it, this scenario illustrates how a very-long-term approach can create opportunities for future generations in a family. And, of course, it’s not necessary to start with $3,000. Even a $1,000 initial gift can yield very rewarding results over a long lifetime.
Think of this as Einstein on steroids.
This topic has many facets. For readers who want to dig into the details for more information, I’ve prepared a page of links to three files that contain year-by-year hypothetical data showing how the plan I have outlined could work.
In addition, I have recorded a podcast called How to turn $3,000 into $50 million. This presentation outlines all the steps that parents and grandparents should consider in setting up this amazing strategy.
Richard Buck contributed to this article.