Roth IRA Growth and Interest: What You Need to Know

Traditionally, retirement savings accounts like a 401(k) and IRA (individual Retirement Account) were advertised as the most effective mediums to save for retirement. A prime reason for the popularity of these savings vehicles is their tax advantages. These retirement accounts allow you to contribute pre-tax dollars and earn tax-free returns on your investments. However, the withdrawals from these accounts are taxed as per ordinary income tax rates. Further, such retirement accounts have some specifications for taking withdrawals, such as a 10% penalty for taking drawings before reaching 59.5 years of age along with the tax charges and more. Apart from withdrawal restrictions, retirement savings accounts like an IRA and a 401(k) also provide limited investment options, restricting your ability to grow your savings over time. However, despite the multiple drawbacks, these tax-advantaged retirement accounts remain a popular saving medium for retirees. On June 30, 2021, 401(k) plans in the U.S. had an approximate balance of $7.3 trillion, one-fifth of the $37.2 trillion U.S retirement market. In 2011, 401(k) assets accounted for 17% of the U.S retirement market with an approximate balance of $3.1 trillion. Alternatively, in the first quarter of 2020, the average IRA balance was $135,700.

However, the increased life span, sharply rising inflation, diminishing interest rates, and heightened retirement savings expectations have pressured retirees, especially in their early saving years, to find different and more beneficial tax-saving vehicles than a 401(k) and an IRA. In this regard, the Roth IRA has taken a front seat. A Roth IRA is a wise way to grow your savings without being restricted by the drawbacks of a traditional IRA or a 401(k) plan. A Roth IRA allows you to contribute after-tax dollars in the account and earn tax-free growth on the sum by investing it across various asset options. This retirement account is preferred over a basic IRA or a 401(k) because the drawings from a Roth IRA do not attract tax charges. This implies that you get tax-free income during retirement, subject to some basic requirements. Even though a Roth IRA and an IRA are similar in some aspects, the two prime retirement savings vehicles have different income eligibility criteria, withdrawal conditions, and more. Hence, it is beneficial to understand Roth IRA in detail, including different aspects like:

• How much can you put in a Roth IRA?
• How many Roth IRAs can I have?
• What is the Roth IRA return rate?
• How does a Roth IRA grow?

Understanding the Roth IRA in an exhaustive manner will help you use this tax-advantaged retirement vehicle to create a large retirement nest egg sufficient to support your ever-evolving retirement living expectations. To do so, you can also reach out to a professional financial advisor who can help assess if creating a Roth IRA account is a suitable retirement strategy for you.

Here is what you need to know about a Roth IRA growth and interest:

What is a Roth IRA?

Roth IRA is an individual retirement account that allows you to contribute after-tax dollars and get tax-free returns on your investments. Apart from tax-free growth, a Roth IRA also gives you tax-free withdrawals, subject to some conditions. In simple terms, you pay taxes on your contributions upfront and allow your money to compound tax-free to get tax-exempt withdrawals during retirement. However, to get tax-and penalty-free withdrawals from a Roth IRA, you have to hold the account for at least five years, and your age must be 59.5 years or more at the time of withdrawal. If you meet both these conditions, the withdrawals are considered qualified and are exempt from income tax.

Roth IRAs were introduced in 1997 but often neglected by wealthy retirement savers. However, in the last few years, the rising tax rates have shifted the focus of retirement savers to Roth IRAs and how to best utilize this account to reduce taxes and amplify retirement savings. Further, IRAs, including Roth IRA, allow even self-employed individuals to save for their retirement, unlike a 401(k) plan, which is only available for private-sector employees.

A Roth IRA is a sound retirement vehicle for those who estimate themselves to be in a higher tax bracket during retirement. Since you pay taxes in the present, you do not owe any taxes to the IRS (Internal Revenue Service) in the future at the time of withdrawal, provided you take qualified distributions.

How much can you put in a Roth IRA? How many Roth IRAs can you have?

Like a 401(k) and a traditional IRA, even a Roth IRA has contribution limitations. For 2021, you can save up to $6,000 per year in a Roth IRA. If you are 50 years or older, the IRS allows you to contribute $7,000 annually in your Roth IRA. However, Roth IRA contributions can only come from earned income. Typically, earned income refers to salary, wages, bonus, freelance income, business profits, commission, and other assignment work. Also, $6,000 and $7,000 are the maximum contribution ceilings for all Roth IRAs. You can hold multiple IRAs. You can even have more than one of the same kind of IRA, implying you can have multiple Roth IRAs, SEP IRAs, and traditional IRAs. But multiple Roth IRAs come with the same contribution restrictions. You can split your money in different Roth IRAs, but it cannot be more than the comprehensive ceiling of $6,000 and $7,000 (if you are above 50 years). If you make contributions above your applicable income ceiling, the IRA will levy a 6% penalty every year until the mistake is rectified. However, these contribution limits do not apply in the case of an IRA rollover, where you transfer funds from an existing employer retirement plan like a 401(k) into an IRA.

However, how much you can put in a Roth IRA is also restricted by income contribution limits and your tax filing status. Therefore, it may be advised to be up to date with the Roth IRA contribution limits along with income eligibility and tax filing status.

What are the income eligibility rules of a Roth IRA?

Your eligibility to contribute to a Roth IRA depends on your Modified Adjusted Gross Income (MAGI). Depending on your tax filing status, you can maximize your contributions, provided your MAGI is less than the specified IRS limit. If your earned income is beyond the IRS-specified MAGI income limits, you cannot contribute to a Roth IRA.

Below is the 2022 Roth IRA table. Use this table to assess your eligibility for a Roth IRA:

If you are eligible to make reduced contributions to a Roth IRA, you can follow these steps to determine your Roth IRA contributions:

• Take your MAGI and subtract these figures from your MAGI:
  • $204,000, if you are married, filing jointly, or a qualifying widow(er)
  • $0, if you are married, filing separately, and you lived with your spouse any time during the year
  • $129,000, for all other cases

   

• Divide the result in the above step by:
  • $10,000, if you are a married and filing jointly, qualified widow (er)
  • $10,000, if you are married and filing separately and you lived with your spouse any time during the year
  • $15,000, for all other cases

   

• Multiply the result in the above with the maximum contribution limit ($6,000 and $7,000 (if you are 50 years or older)
• Subtract the result of the above step from the maximum contribution limit before any reduction.

The answer is the reduced sum you can contribute to a Roth IRA per your applicable tax status and income eligibility.

How does a Roth IRA grow? What is the Roth IRA return rate?

Unlike a savings account, there are no Roth IRA interest rates. A Roth IRA account is like an empty basket, and the returns from the basket depend on the chosen investments. You have to invest your Roth IRA savings in different securities to generate returns. Typically, a Roth IRA allows you to invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposits (CDs), and money market accounts. The investment options in a Roth IRA are much broader than a traditional IRA and a 401(k) account. However, even a Roth IRA restricts you from investing in real estate, cryptocurrency, LLC membership interest, and precious metals. Those interested in investing in these alternate class assets can opt for a self-directed Roth IRA, which allows you to invest across alternative asset classes and avail the same tax advantages as a Roth IRA.

Your Roth IRA return rate depends on the performance of your underlying investments. The interest and dividend earned by your portfolio are added to your Roth IRA balance. How much a Roth IRA grows depends on the investments it contains. You choose the securities that comprise your Roth IRA basket. These securities earn interest and dividends, compounded over time, allowing your money to grow faster. All earnings on your investments are added to the Roth IRA balance. You earn interest on the accumulated interest and dividends, and this process continues over time. Hence, even if you do not make regular contributions to your Roth IRA, your funds will grow until withdrawn.

That said, even though there is no fixed Roth IRA return rate, several factors can impact how much your money grows. Some of these factors are portfolio diversification, investment time horizon, risk tolerance, and portfolio composition. Historically, the average Roth IRA return was between 7% and 10%. So, if you contribute $6,000 in your Roth IRA for 15 years, and your investments earn an average Roth IRA return of 7%, you will have approximately $151,050 by the end of the 15 years. However, if you do not open a Roth IRA and secure your money in a savings account, you will have only $90,000 by the end of the ten years ($6,000 *15) as there is no interest or dividend accumulation. The longer your investment period, the greater is the power of compounding.

How does a Roth IRA grow?

You can use this example to comprehensively understand how a Roth IRA grows:

• Annual contributions = $4,000
• Contribution period = 20 years

You have a Roth IRA investment of $80,000. Your account earns a modest $5,000 in interest, accumulating a total balance of $85,000 ($80,000 + $5,000). You take this total balance of $85,000 and invest in a mutual fund scheme that has an average return of 8%. Therefore, after the end of the first mutual fund investment year, your Roth IRA has $6,400 as simple interest ($80,000 multiplied by 8%) and $400 as compound interest ($5000 multiplied by 8%), giving you a total of $91,800. The same process will continue for as long as you do not make withdrawals. Even if you do not contribute after 20 years, your savings will earn compound interest until withdrawn from a Roth IRA.

There are no RMD (Required Minimum Distribution) restrictions in a Roth IRA. In a traditional IRA, the IRS mandates you to take RMDs from your account when you turn 72. Failure to take RMDs by the due date or in the full amount can lead to severe penalties. However, this rule is not applicable to a Roth IRA. You are not bound to take withdrawals from your Roth IRA if you do not need to. You can leave your funds to accumulate for your lifetime and keep contributing to it indefinitely, provided you meet the income eligibility criteria.

How to maximize Roth IRA returns

You can maximize your Roth IRA returns by choosing high-return securities like stocks. However, stock investments carry high risk and are advisable for investors with a longer time horizon to absorb market volatility. Hence, if you want to maximize your Roth IRA returns, your timing plays a critical role. The earlier you start investing, the higher is your risk tolerance, allowing you to invest in high-return securities, like stocks. Further, investing for a long period allows your Roth IRA funds to significantly benefit from the power of compounding.

Alternatively, the custodian of your Roth IRA also impacts your maximizing potential. If you choose a Roth IRA from a traditional bank, you will get limited investment options. For instance, you might invest in certificates of deposits, which pay out a lower rate of return. However, if you want diverse investment options to choose from, it is beneficial to open a Roth IRA through a financial advisor. In such an account, you can choose the investments per your financial goals and risk appetite. Ideally, you can create an optimally diversified portfolio comprising a mix of stocks, bonds, index funds, mutual funds, and exchange-traded funds (ETFs).

To maximize Roth IRA returns, be careful to choose an account with the lowest charges, such as account maintenance fees, trading fees or commissions, mutual fund expense ratios, mutual fund loads, etc.

What are the withdrawal rules of a Roth IRA?

To withdraw money from a Roth IRA, you have to fulfill some conditions:

• You have to hold the Roth IRA for at least five years or more.
• You can take distributions from your Roth IRA only after the age of 59.5.

Technically, you can take drawings from your Roth IRA at any age or time without paying any penalties or taxes, provided your drawings comprise only the original contribution. This is because you have already paid taxes initially on the contributions and can take the sum without any add-on charges. However, you will pay taxes on the earnings component taken out from the Roth IRA. But if you comply with the five-year and 59.5 age rules, you do not owe any taxes on the sum withdrawn from a Roth IRA, inclusive of earnings.

Apart from knowing the withdrawal rules, it is also critical to understand the withdrawal structure of your Roth IRA. When you withdraw any sum from a Roth IRA, the IRS gives the first distributions from your original contributions. The following withdrawal comes from conversions and Roth rollovers (on first-come-first-go criteria), and the last drawings are from earnings. Hence, even though you do not pay any taxes or penalties on the original contributions, you pay taxes and penalties on the following distributions if you do not comply with the Roth IRA withdrawal rules (non-qualified distributions).

That said, in some instances withdrawing early from a Roth IRA is tax-free even if it is non-qualified. For instance, money taken from a Roth IRA for a first-home purchase up to $10,000 is tax-free even if it is before 59.5 years or the five-year account holding expiration. Some other circumstances that qualify for tax-free withdrawals at all times from a Roth IRA are:

• Post-secondary education fees
• Permanent disability
• Health insurance premiums during unemployment
• 10% of unreimbursed medical costs

To summarize

If you understand how a Roth IRA works, and its growth and interest components, you can tap this potentially beneficial account to create a desirable retirement account balance for your future. Better tax advantages, wide investment options, flexible withdrawal rules, and the absence of RMDs make Roth IRA a preferable choice over a traditional IRA or a 401(k) plan. However, it can be beneficial to seek guidance from a professional financial advisor and create a diversified portfolio with the best Roth IRA investments as per your risk tolerance and financial goals. Use the free advisor match service and get matched with 1-3 fiduciary financial advisors that are suited to meet your financial requirements.

To learn more about the most suitable retirement accounts for your unique financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. In addition, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.