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

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