And if you continue to make regular contributions to your IRA, you’ll see a dramatic effect on the performance of your account.
IRA Contribution Limits for 2020
- The maximum IRA contribution limit for 2020 is $6,000.
- Workers 50 years and older can make a catch-up contribution of $1,000 more, for a maximum possible IRA contribution of $7,000 in 2020.
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IRA Growth: The Power of Compounding
To reduce the effect of inflation, it is important that you invest in investments such as mutual funds, individual equities, or index funds whose rate of returns beats the historical inflation average. You can also invest your IRA in a range of securities offered by several entities, including limited liability companies (LLCs), limited partnerships (LPs), limited liability partnerships (LLPs), public corporations, and general partnerships (GPs).
Stocks are popular investments held in IRAs. This is because the earnings generated add to contributions. As stocks grow in their price and dividends, the balance in your IRA grows. Historically, despite the market fluctuations, the annual range for stock investments has been between 8% and 12%.
For example, if you invest $5000 every year in a stock index fund for 30 years with an average return of 10%, your account will grow to over $1 million. In stocks, your funds show great potential to grow over time dramatically, and that’s the magic of compounding!
Investments such as bonds are more stable and are often included in IRAs because they help diversify the portfolio and also balance out the equities’ volatility with a stable income.
Read this article to know more about what should be your choice for investment – Real Estate or Stocks?
Roth vs. Traditional IRA
The traditional IRA is funded with pre-tax dollars. This means, when you retire, you are liable to pay income tax on funds to withdraw from a traditional IRA.
However, the Roth IRA is funded with after-tax dollars. This means, when you withdraw the funds in retirement, you are not liable to pay income tax.
Roth IRA Growth [With Example]
The investments in your retirement account earn dividends and interest, which gets added to the account balance. How much earnings your investments generate depends on the type of investments you hold in your account. Even if you cannot make any contributions to the account, your account balance will grow because of the interest you earn on balance and the interest you earn on interest. Thus, your Roth IRA grows over time. Another feature that makes it an excellent vehicle for growth is that there’s no Required Minimum Distribution for Roth IRA.
Assume that you contribute $3,000 to your Roth IRA every year for 20 years. Your total contribution is $60,000.
The $60,000 balance in your account earns an interest of $5,000, making it to a total of $65,000. To grow your account, you decide to invest in mutual funds, which gives 8% interest annually.
Assume that you stop contributing to your Roth IRA after 20 years.
- You earn 8% on the total balance of $65,000.
- You earn $4,800 in simple interest ($60,000 in contributions multiplied by 8%).
- You earn $400 in compound interest ($5,000 of earnings multiplied by 8%).
- Your account balance thus increases to $70,200.
The second year without making any contributions
- You continue to earn 8% on $70,200 (the sum of your contributions and previous earnings). That’s another $5,616 in total interest, making a total balance of $75,816.
- In just two years, you gained nearly $11,000 without making any additional contributions.
The third-year without making any contributions
- You earn $6,065 on $75,816, increasing your balance to $81,881.
- Another five years without you making any contributions
- You earn another $38,429 in interest, increasing your total balance to $120,310.
- You see that in the past eight years, your Roth IRA nearly doubled without you making any contributions to it. This example of Roth IRA growth clearly shows the power of compounding.
How can you maximize your Roth IRA returns?
- Start early
- If you have a traditional IRA, consider transferring it to a Roth IRA.
- Diversify your investment portfolio among different asset classes, such as stocks, bonds, real estate, etc. By diversifying your portfolio, you can control risk.
Roth IRAs grow by taking advantage of the power of compounding. Even if you manage to make relatively small annual contributions or no contributions at all, your account balance can grow significantly over time. Start contributing to your IRA early, if you want to make the most out of compounding and to have a well-funded retirement.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.