Your Roth IRA returns are determined by the investments you hold in the account—not by a set interest rate. One day, those returns will exceed your annual contributions, thanks to the power of compounding.
- A Roth IRA is a tax-advantaged way to save for retirement.
- Setting financial goals can help you make sure you’re saving enough for retirement.
- One day your earnings will exceed your annual contributions because of the magic of compounding.
When you stash away money for retirement, are you working toward a specific investment goal in your 401(k), traditional IRA, and Roth IRA accounts—or are you maxing out your annual contributions just to minimize your tax bill?
The answer to this question is more important than it might seem. When you save and invest money, you should have a target in mind—a certain portfolio size that confirms you’re on track for your life after work. Until you establish such a goal, there’s no objective way to know if you’ve saved enough.
The number of people in the U.S. who say they don’t know how much they’ve saved for retirement.
If you haven’t set an investment goal yet, you can figure out how much money you’ll need in your nest egg to fund the retirement lifestyle you want. Here’s how.
Step 1: Estimate How Much Income You’ll Need in Retirement
This step can get really involved if only because you’re attempting to project expense levels for a life you’re not currently living.
To keep it simple, many financial planners recommend using 80% of your current income as a yardstick. For our example, we’ll assume an income of $10,000 per month, which at 80% is $8,000, or $96,000 a year.
Step 2: Subtract Expected Monthly Social Security and Pension Benefits
You can find this information in your annual Social Security Earnings Record and your company’s human resources department. Subtract these benefits from your expected monthly retirement income from Step 1. If you have other sources of guaranteed income—such as monthly annuity payments—subtract those, too.
For our example, we’ll assume monthly Social Security and pension income will be $4,000 per month. This reduces the income we’ll need at retirement to $4,000 per month or $48,000 per year.
Step 3: Factor In Time Horizons
There are three numbers to be concerned with here: your current age, your expected retirement age, and the number of years you expect to live after you leave the work world behind.
You can use life expectancy charts to determine how long you can be expected to live as a retiree, but it can be just as easy to consider the longevity of your close relatives, and then round up.
For our example, we’ll assume a current age of 35, an expected retirement at age 65, and that you’ll probably live for 20 years in retirement.
Step 4: Determine the Rate of Return on Investment (ROI) You Expect on Your Retirement Assets
Of course, there’s no way to do this scientifically, but the long-term ROI in the stock market is about 8%. You can expect a lower rate of return on your retirement assets once you retire since, in all probability, you’ll have your money in more conservative investments.
For our example, we’ll assume an ROI—or interest rate—of 8% until retirement, and then 5% after that.
Step 5: Account for Inflation
It’s a good idea to account for inflation, as it can have a major effect on the outcome of your plans. For our example, we’ll assume a 3% inflation rate.
Step 6: Put It All Together
Here's what we have so far:
- Required yearly retirement income: $48,000
- Current age, 35; retirement age, 65; and years in retirement, 20
- Rate of return: 8% before retirement; 5% during retirement
- Annual expected inflation rate: 3%
You can use an online calculator to do the math. Using the figure from our example, you’ll need to accumulate about $1.97 million to retire at age 65 with 80% of your current income.
Presto: Your Retirement Investment Goal
Now you have a goal to shoot for with your retirement investments—$1.97 million. When you make contributions, you’ll know how close you are to reaching your goal, and what steps might be needed to move up to where you want to be.
Saving for retirement seems like a daunting task with an end goal far off in the future. You have to be incredibly disciplined with your savings on a monthly basis month after month, year after year—until you hit retirement age.
You need the wisdom to avoid jumping into hot stocks or sectors of the market and instead hold to your portfolio diversification.
Planning to never retire is not a realistic retirement plan. It's possible you'll get forced into retirement unexpectedly.
But as difficult as saving for retirement can be, there’s one part of retirement saving that’s on your side: compound interest.
Your Retirement Ally: Compound Interest
Even if you’re contributing the max to your Roth IRA and are incredibly disciplined in doing so year after year, your contributions alone won’t be enough to make that retirement nest egg goal. That’s where compound interest comes to the rescue.
Compound interest is the interest that accrues on your contributions and on the accumulated interest of that principal. It’s interest on the interest you’ve earned in the past.
Compounding of interest allows an invested sum to grow at a faster rate than simple interest, which is calculated just on the principal alone.
Let’s look at an example using $12,000 in annual contributions (let’s say you and your spouse each contribute $6,000 a year to a Roth IRA).
If your $12,000 deposits earn 8%, the simple interest for that year would be $960. Your accounts would collectively end the year at $12,960. The next year, the combined balance would be $25,920.
Now let’s say your Roth IRAs earn interest at an 8% compounded rate. At the end of the first year, you’d have the same balance as if you earned simple interest: $12,960.
But at the end of year two, instead of $25,920, you’d have $26,957 because of the extra interest you'd earn on the first year's interest. Not a huge difference yet, but still more than the simple interest would earn.
Of course, the more years that pass, the larger the effect of compounding. Here’s what happens to your earnings over the next five years:
- Year 1: $960
- Year 2: $2,957
- Year 3: $6,073
- Year 4: $10,399
- Year 5: $16,031
Magic for Retirement Funds
In Year 5, your account growth suddenly exceeds your annual contributions. And as your account continues to grow, that increase gets larger and larger, eventually adding $67,746 to your account in Year 10. That’s 564% more than your annual contribution.
Granted, this is based on a fixed rate of return of 8% for 10 years in a row. In real life, the stock market and your investments will not see such steady returns. Some years you'll see 25% growth, while others could be 15% losses. Still, 8% is the long-term ROI in the stock market, so it's a reasonable average to target.
Over time, your contributions will exceed what you put into the account on an annual basis. But just because your account grows more than $12,000 in a year doesn’t mean you stop making contributions. A key component of growth is having a large contribution base. So stay dedicated and keep funding the account (to the max, if you can) every year.
The Bottom Line
Will a Roth IRA be enough to reach your $1.97 million nest egg goal? Probably not, since you can only contribute up to $6,000 a year.
A Roth has fantastic tax advantages (tax-free withdrawals in retirement and no RMDs). But it's only one part of a well-rounded retirement savings plan. If you have a 401(k) at work, that's another good option—especially if your employer offers matching contributions.
Retirement planning is serious business (you only get one shot at it). It can be helpful to work with a qualified financial planner or advisor who can help you set your goals for retirement, and make a plan to reach them.