It wasn’t until a recent episode of Suze Orman did I fully grasp the potential of IRA’s and the power of compound interest. When you sit down and work out the math it’s really quite amazing how simple steps we can take while we’re young, say, saving $100 a month, can turn into millions by the time we retire.
The Basics:
With Roth IRA’s you can deposit up to $4,000 per tax year. (5k starting in 2008 ) You don’t have to put in that much, it could be $25 a month or $100 a month, whatever you can afford. You put it in with after-tax dollars and it grows tax-free. So that when you pull the money out when you’re 59 1/2 (or later) you don’t owe capital gains taxes on all the interest you’ve earned. Any other regular investments you do have to pay taxes say, if you have stocks/investments outside of a Roth IRA account.
To illustrate:
John* starts putting $100 a month in his Roth at age 25 until he’s 65. When he retires he’ll have $1,100,000. (assuming compound interest around 8%)
Bob doesn’t start putting money in his Roth until he’s 35. He then puts the same $100 every month until he reaches 65. When he retires he’ll only have $300,000!!!
Those 10 years of not investing cost him $700,000 OMG!!
For Instance:
Billy at 25, puts away $300 every month until he is 40. He would have put in $54,000 over those 15 years but the account would then be worth $104,500.
If Billy never makes another contribution beyond age 40, (assuming again average annual return of 8%), compound interest after another 30 years will make his account worth $1,050,000.
Jimbo, never wanted to think about his retirement. Then by his mid-life crisis realized he needed a nest egg. At age40, he began investing that same $300 a month for the next 30 years. After investing $108,000 cash, his account is only worth $450,000 at age 70.
So even though Jimbo invested twice as much money as Billy he ended up with half as much simply because Billy had longer time for compounding to work in his favor. Time is key here, not money.
Another example:
Jane starts investing $2,000 a year at age 19 and does so until she’s 25 and then stops contributing completely. Her $14,000 cash that she invested over the 7 years will have grown to $930,600 by age 65.
Sally starts at 26 years old and puts $2,000 until age 65. Her $80,000 cash investment over 40 years amounts to $893,700.
For emphasis, the younger you start, the longer you have for compound interest to work for you. You could either be out $14k or $80k for practically the same result.
Now, the beauty of Roth IRA’s is that you can withdraw the principal (the cash amount you put in) any time without any penalties or taxes. So an IRA can double as your emergency fund. I’m talking real emergency because if you pull the money out early, you’re still limited to only putting back $4k a year so you could lose out on some potential growth.
If your interested in doing this, which I highly recommend for everyone, it’s as easy as finding an online discount broker (I use Scottrade) and open an account online; just as you would a regular savings/checking account. With Scottrade, the minimum initial investment is $500. AND you can deposit contributions into an IRA up to April 15th, 2008 and have them count towards your 2007 year taxes. (you just have to put in the memo line Tax Year 2007 Contribution)
Additionally, if you’re good about picking investments (stocks, bonds, ETF’s, mutual funds) with higher yields than 8% you could potentially retire in your 50’s and have millions to sit on… AND, again, you can always pull the money back out, not the interest you’ve earn, but the principal, in case you’re ever in a bind.
An extra incentive to max out now: the current law that governs the contribution limits will expire in 2010 and Congress will then reconsider what the limits should be set to. They may decide to go back to the max limit of $2,000 as it was in 2001. So if you can, try to take advantage of the full contribution limit while it’s still a guaranteed limit.
*Names have been changed
May 9, 2008 at 12:32 am
Hello I have a quick question for you. In your article, you stated that…
John* starts putting $100 a month in his Roth at age 25 until he’s 65. When he retires he’ll have $1,100,000. (assuming compound interest around 8%)…
But how is Roth IRA a compound interest? Since it’s stock/mutual fund base? I know how IRA works and all the facts about it, I personally have one as well, but my quesiton is, I just don’t understant how it would grow to 1 million if the stock goes up and down. How does compound interest work within IRA?
I’ve been searching this simple question for months now and no one can tell me anything other than how Roth works. (which I already know, and I also know that it grow), but just… how???
May 10, 2008 at 7:28 am
I had the same question myself and have had trouble getting an answer as well. I think the biggest compounding factor is not interest, but rather returns from dividends and capital gains that are paid out and reinvested in the security.
May 11, 2008 at 6:24 pm
The way compound interest works within the IRA is that as your principal investment amount grows, you now have principal + gain, reinvested. Over the course of 10+ or 20+ years that you’d have your money invested in an IRA, naturally it will go up and down, but this is an AVERAGE over the years at a conservative 8%. Some years it might lose 5% but then others gain 12%…but on average that’s 8%. Your gains become reinvested into your lump sum that’s now ‘earning’ (subject to the economy) an average of 8% over the span of many years.
June 23, 2008 at 12:20 am
here is something to think about. if, in your ira you have 10 dollars and the market goes down 25 percent you would have $7.50. pretty straight forward. next year the market goes up 25% again. you’re right back where you started right? wrong! if you do the math, it would take a 33% return, not a 25% return JUST to get you to square one again. capital preservation is the key. how do you do it? through an index fund that you don’t sell when the market is down. if it is share value in your portfolio that is down, it is still only a paper loss. the moment you sell you will realize this loss. there are many other, BETTER ways to accomplish capital preservation with an acceptable rate of return, the best being indexed universal life insurance. i currently have a policy with pacific life that lets me participate fully in any positive market movement. if the market is negative that year, i get a guaranteed 1% return. preservation of capital with all the upside potential.
BTW, suze orman is a best selling author only because she panders to people who don’t have financial savvy, instead of educating them. read douglas andrew and nelson nash to get you started on a real path to wealth.
November 19, 2009 at 5:06 pm
I’ll be thirty four this year and wanted to know what IRA or tax sheltered accounts would be best for me.
Is it possible to put more into an IRA per year as of now to make up for what wasn’t placed aside ten years ago?
Thanks!
November 19, 2009 at 5:14 pm
I’ll be thirty four this year and wanted to know what IRA or tax sheltered accounts would be best for me.
Is it possible to put more into an IRA per year as of now to make up for what wasn’t placed aside ten years ago? more than one
Also, is it logical to have more than one IRA ?
Thanks!
November 22, 2009 at 10:21 pm
You can only play catch up if you’re 50 years or old. So your maximum contribution can only be $5,000. You could open multiple Roth IRA’s however, the total combined contribution is $5,000 for 2009. If for some reason you wanted put a $2500 with one bank and another $2500 with another financial instituion you could, although I really don’t see much benefit to doing this. See this article at Get Rich Slowly which features many questions and answer on Roth IRA’s.
April 12, 2011 at 5:40 pm
QUESTION–I’m 27. If I start NOW and put $50 bucks a month in until I am 65–how much would I more than likely have if I NEVER touch it?
November 14, 2011 at 6:48 pm
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