Compound interest is perhaps the smartest investment strategy one can take regardless of their investment of choice. The name of the game is to let your money work for you by earning interest on both the initial investment and the accumulated interest. However, what happens when the interest is not reinvested?
The interest rate is not only important for people who owe money, but also for people who save money. When interest is earned on investments but not reinvested, it can impact the overall growth of the investment. This can be seen in short-term investments like CDs, short-term bonds, and money market funds, which have grown in popularity since interest rates started rising more than 2 years ago.
Dividend Reinvestment Plans (DRIPs) are popular among investors for their ability to automatically reinvest dividends into additional shares of a company's stock. However, when interest is not reinvested, the growth potential of an investment may be limited.
The IRS treats interest you earn on a CD as income, whether you receive the money in cash or reinvest it in a new CD. The interest is taxable regardless of whether it is reinvested or not. This can have implications for the overall return on investment for individuals who choose not to reinvest their interest.
Using a compounding interest calculator can help investors determine how much their money can grow over time with compound interest. By inputting variables such as initial investment, interest rate, and time horizon, investors can see the impact of reinvesting interest versus not reinvesting it.
Schwab One Interest and Bank Sweep are two primary cash features that allow investors to earn interest on uninvested cash in their brokerage accounts. The Money Fund Sweep is an additional cash feature available to certain accounts, providing further opportunities for earning interest without reinvestment.
Interest earned on National Savings Certificates (NSC) is taxable under the head "Income from Other Sources." However, the interest is reinvested for the initial 4 years, meaning it will not be taxed until the interest is withdrawn or the investment matures.
In conclusion, while compound interest is a powerful tool for growing investments, the decision to reinvest interest can have a significant impact on the overall growth potential. By understanding the implications of not reinvesting interest, investors can make informed decisions about how to maximize the growth of their investments.
