401(k) Tips

How often does 401k interest compound?

One of the advantages of saving money in a 401(k) is the power of compounding. Find out how often your 401(k) interest compound.

3 min read

If you want to join the league of 401(k) millionaires, you should explore how to use compound interest to grow your retirement savings. When you contribute to a 401(k), the money is invested in various assets like mutual funds and bonds. Which grow over time through compounding. But, how often does 401(k) interest compound?

401(k) interest earnings can compound either monthly, quarterly, or annually, depending on the type of investments in your 401(k). If you hold funds that earn interest, you have to reinvest these earnings to enjoy the benefits of compounding. An investment will grow at a faster pace when it compounds monthly than if it compounds annually.  

What is Compound Interest?

Compound interest is the interest earned on the initial investment and any accumulated interest from the previous period (s). This means that you earn interest on the interest that you have already earned.

Compound interest is different from simple interest. While simple interest is earned only on the original deposit, compound interest takes into account the initial investment amount and any interest gained since you put 401(k) money into the investment. Hence, your investment will grow at a faster pace with compound interest than with simple interest.

How does compound interest work in a 401(k) plan?

A 401(k) plan is offered by an employer to help employees save for retirement. The amount contributed to a 401(k) has to be invested in an interest-earning investment to compound. Depending on the assets you hold in your 401(k), the interest earnings could compound monthly, quarterly, or annually. The 401(k) money grows when it is invested in funds that have bonds and stocks.

Since a 401(k) is a tax-deferred retirement plan, you don’t pay taxes upfront on the contributions you make. Instead, every dollar you contribute can be invested to earn a return. The returns you earn are invested back into your 401(k) to continue compounding until when you decide to take a distribution from the account.

If a 401(k) investment compounds more frequently, either monthly or quarterly, your retirement savings will grow more rapidly than an investment that compounds yearly. For example, assuming you have contributed $10,000 at 5% and it compounds daily, you will have $10,618 at the end of the first year and $11, 275 at the end of the second year. However, if the investment compounds yearly, you will have $10,600 at the end of the first year, and $11,236 at the end of the second year.

Do 401(k) dividends earn interest?

When you invest your 401(k) money in mutual funds, you will earn dividend income periodically depending on how the investment performs. You may also earn dividends if you hold the employer’s company stock in your 401(k). The dividend income represents small bonuses paid out from the issuing company's profits.

Although dividend income does not gain interest on its own, you can earn interest if you chose the reinvest the money into more shares of stock. You can let the reinvested dividend income grow through compounding until when you are ready to withdraw money from 401(k). However, if you opt to receive the dividend payments, you won’t earn compound interest on the money.

How to take advantage of compound interest

Since a 401(k) is made up of a diversified portfolio, your interest earnings could compound monthly, bi-annually, or annually. This means your investment will experience different growth rates over your working years.

You can take advantage of compound interest in your 401(k) by increasing your 401(k) contributions up to the annual contribution limit so that you will have more money to invest.

You should also start saving early in your career, since the longer your interest compounds, the faster your earnings will grow. Investing the retirement savings early will allow the compound interest to snowball into large investments by the time you retire.

You should also take advantage of company matching to draw more money from your company. You should contribute enough to receive the full match. Instead of taking too many risks with your 401(k) money, you should let the investment professionals in your 401(k) plan manage the investment for you.

How to take advantage of compound interest in your 401(k)

If you want to grow retirement savings through the power of compounding, there are several strategies you can use. These strategies include:

Start saving early

If you start saving early in your career, your retirement savings could grow exponentially through compounding. Join a 401(k) as soon as you get your first job and start accumulating retirement savings.

Max out your contributions

If you recently got a raise or started a business, you can increase your retirement contributions up to the annual contribution limit. For example, if you contribute 7% of your salary for retirement, you could increase this percentage to 10% or 15%, depending on how much you can afford.

Invest savings

When you contribute to a 401(k), you should create a balanced portfolio comprising mutual funds, bonds, and stocks. If you are still young, you can invest in high-risk high-return assets since you have a longer time to weather stock market fluctuations. However, as you approach retirement age, you should move from aggressive to conservative investments to minimize risk exposure.