Traditional individual retirement accounts (IRAs) are known for their tax advantages, but how does a Roth IRA work—specifically, how does it grow over time? Your contributions help, but it’s the power of compounding that does the heavy lifting when it comes to building wealth with a Roth IRA.
Your account has two funding sources: contributions and earnings. The former is the most obvious source of growth, but the potential for dividends and the power of compounding can be even more important.
- A Roth IRA provides tax-free growth and tax-free withdrawals in retirement.
- Roth IRAs grow through compounding, even during years when you can’t make a contribution.
- There are no RMDs, so you can leave your money alone to keep growing if you don't need it.
What Is a Roth IRA?
IRAs, both traditional and Roth, are popular savings vehicles among those who understand the importance of planning for retirement. It's easy to open an account using an online broker or with the guidance of a financial planner.
The defining characteristic of a Roth IRA is the tax treatment of contributions. For a traditional IRA, contributions are made with pretax dollars, meaning you pay income tax when you withdraw the funds later. Contributions to Roth IRAs, conversely, are made with after-tax dollars. Thus, any contributions you make are yours to withdraw tax-free at your discretion. Earnings, however, generally cannot be withdrawn until the account has been open for five years and you reach the age of 59½ without incurring taxes and penalties. Qualified withdrawals of both contributions and earnings in retirement are also tax-free.
With traditional IRAs you get a tax break now and pay taxes later; with Roth IRAs, you pay taxes now and get a tax break later.
Many employees rely on the retirement savings accumulated through payroll deferrals made to an employer-sponsored savings plan such as a 401(k). However, IRAs allow anyone—even the self-employed—to contribute during their working years to ensure financial stability later in life.
Roth IRA Growth
Whenever the investments in your account earn a dividend or interest, that amount is added to your account balance. How much the account earns depends on the investments they contain. Remember, IRAs are accounts that hold the investments you choose (they are not investments on their own). Those investments put your money to work, allowing it to grow and compound.
Your account can grow even in years in which you aren't able to contribute. You earn interest, which gets added to your balance, and then you earn interest on the interest, and so on. The amount of growth your account generates can increase each year because of the magic of compound interest.
No Required Minimum Distributions for Roth IRAs
With traditional IRAs, you have to start taking required minimum distributions (RMDs) when you turn 72, even if you don't need the money. That's not the case with a Roth IRA. You can leave your savings in your account for as long as you live, and you can keep contributing to it indefinitely, as long as you have qualifying earned income and your modified adjusted gross income doesn't exceed the annual limit for making contributions.
These features make Roth IRAs excellent vehicles for transferring wealth. When your beneficiary inherits your Roth IRA, generally he or she will have to take distributions, but they can be stretched out over the beneficiary's lifetime. This can provide years of tax-free growth and income for your loved ones.
Roth IRA Growth Example
Here’s an example. Assume you contribute $3,000 to your Roth IRA each year for 20 years, for a total contribution of $60,000. Keep in mind that as of 2020 you can contribute up to $6,000 ($7,000 if you’re age 50 or older), provided you meet the income limits. In addition to your contributions, your account earns a very modest $5,000 in interest, giving you a total balance of $65,000. To ramp up your savings, you decide to invest in a mutual fund that yields 8% interest annually.
Even if you stop contributing to your account after 20 years, you earn 8% on the full $65,000 going forward. The next year you earn $4,800 in simple interest ($60,000 in contributions multiplied by 8%) and $400 in compound interest ($5,000 of earnings multiplied by 8%). This increases your account balance to $70,200
The following year you continue to earn 8% on the sum of your contributions and previous earnings, yielding another $5,616 in total interest. Your balance is now $75,816. You gained nearly $11,000 in just two years without making any additional contributions. In the third year, you earn $6,065, increasing your balance to $81,881.
If you fast forward another five years, your account earns another $38,429 in interest, and your total balance is $120,310. Without making any contributions to it, your Roth IRA has nearly doubled in the past eight years through the power of compound interest.
Scott Snider, CPF®, CRPC®
Mellen Money Management LLC, Jacksonville, Fla.
Think of the Roth IRA as a wrapper around your money that provides tax-deferred growth, so that when you retire you can withdraw all of the contributions and earnings tax-free. Roth IRAs are especially appealing to younger investors because the growth can be as high as four to eight times what they originally invested by the time they retire.
The actual growth rate will largely depend on how you invest the underlying capital. You can select from any number of investment vehicles, such as cash, bonds, stocks, ETFs, mutual funds, real estate, or even a small business. Historically, with a properly diversified portfolio, an investor can expect anywhere between 7% to 10% average annual returns. Time horizon, risk tolerance, and the overall mix are all important factors to consider when trying to project growth.
Max Out Your 401(k) Match First
Of course, a Roth IRA shouldn't be the only way you work on building a nest egg. If you have access to a 401(k) or similar plan at work, that’s another great place to save for retirement. Here’s why.
- If you get an employer match, you get an automatic 100% return on part of the money you invest in your 401(k).
- 401(k)s are tax-deferred, so your money grows faster.
- You get a tax deduction for the year you contribute, which lowers your taxes (and gives you more to invest).
- There are high contribution limits: For 2020 you can invest up to $19,500, or $26,000 if you’re age 50 or older.
A good strategy is to fund your 401(k) first to ensure you get the full match, and then work on maxing out your Roth. If you have any money left, you can focus on rounding out your 401(k).
The Bottom Line
Roth IRAs take advantage of the power of compounding. Even relatively small annual contributions can add up significantly over time. Of course, the sooner you get started, the more you can take advantage of compounding—and the better your chance of having a well-funded retirement.