Individual retirement account (IRA) growth depends on many factors. It relies heavily on the amount of money invested and how much risk the investor will assume, which shapes the types of investments included in the account. Making regular contributions to the account also has a dramatic effect on the performance.
How Contributions Affect Growth
One big factor that determines the growth of an IRA is contributions. As of 2020, IRA contributions are limited to $6,000 a year (no change from 2019), or $7,000 ($6,000 + $1,000 catch-up contribution) if you are age 50 or over. If $6,000 is invested annually in an IRA at a return of 5% after 30 years, the account would be worth over $400,000. The fact that the interest can be reinvested and grow tax-free doesn't hurt either.
- IRA growth depends on its underlying investments, how much money is invested, and other factors.
- As of 2020, contributions into traditional and Roth IRAs are limited to $6,000 per year ($7,000 for individuals age 50 or older).
- Investors fund traditional IRAs with pretax dollars and Roth IRAs with post-tax dollars.
- At age 72, traditional IRA owners must take required minimum distributions.
The Magic of Compounding
Of course, to beat inflation, it is necessary to invest in higher-risk investment vehicles, such as individual equities, index funds, or mutual funds. IRAs can invest in a range of securities offered by various entities: public corporations, general partnerships (GPs), limited partnerships (LPs), limited liability partnerships (LLPs), and limited liability companies (LLCs).
Investments held in IRAs that are related to these entities include stocks, corporate bonds, private equity, and a limited number of derivative products. Not every investment is eligible for an IRA (e.g., antiques or collectibles, life insurance, and personal-use real estate).
Stocks are a popular choice for IRAs because the earnings gained are basically extra contributions to the IRA. Stocks also grow IRAs through dividends and increases in the share price. While no one can predict the future, the annual range of return for stock investments has historically been between 8% and 12%.
For example, by investing $6,000 a year in a stock index fund for 30 years with an average 10% return, you could see your account grow to over $1 million (though be aware of the impact of investment fees). With such great potential to grow funds consistently over time with the magic of compounding, it is clear why stocks are almost always featured in IRA accounts.
Higher-risk investments, such as stocks, help grow IRAs most dramatically. More stable investments, such as bonds, are often included in IRAs for diversification and to balance out the equities' volatility with a stable income.
Roth vs. Traditional IRA
The main difference between the two kinds of IRAs is whether you want to fund your IRA with pre- or post-tax dollars. A traditional IRA is funded with pre-tax dollars. When you retire and access funds in a traditional IRA, you are responsible for paying income tax on the funds. A Roth IRA is funded with after-tax dollars, and any contributions made are not subject to taxes when withdrawn. Contribution limits for Roth and traditional IRAs are the same, and both can be funded up until any age.
If you opt for a traditional IRA, you must take a required minimum distribution (RMD) starting at age 72. As per the IRS, traditional IRA owners must begin taking minimum amounts beginning April 1 of the year following the year they turn 72. Beneficiaries are also subject to the RMD rules if they inherit a traditional IRA. Non-spousal beneficiaries who inherit Roth IRAs are also subject to RMD rules.
Opening an IRA
An IRA can be opened through a financial institution, such as a brokerage, mutual fund company, insurance company, or bank. IRAs can also be opened through online brokerages. The major difference between most IRA providers lies in what they charge for their services.
Just about any wage-earner can set up an IRA. Employers or self-employed individuals who want to establish retirement plans for themselves or their employees often consider simplified employee pension individual retirement accounts (SEP IRA). SEPs have lower costs for setup and maintenance than traditional retirement plans do.
The Bottom Line
Few investment vehicles are as versatile as IRAs. Many options are available for investors to personalize accounts to help reach their financial goals, and thanks to compounding interest, IRAs will continue to grow even if you are unable to fund them every single year.
A valuable tool for investors of any experience level, IRAs offer the flexibility to be hands-on or to leave the choices to the professionals. With so many options for funding IRAs and the probability for high returns, it is no surprise that over 30% of households contribute to either a traditional or Roth IRA.