The investments held in a Roth IRA account determine the return, not the interest rate. One day, those returns will exceed the annual contributions, thanks to the power of compounding.
When you save for retirement in your Roth account, it’s important that you work toward a specific investment goal rather than just maximizing your yearly contributions in order to minimize your tax bill. When you save and invest, you should have a target in mind and a portfolio designed to ensure your future financial health. Until you establish such a goal, there is no objective way to know if you are saving enough.
If you have not yet determined an investment goal, here is a formula for estimating how much you’ll need in your nest egg to fund the retirement lifestyle you want.
Step 1: Estimate the Income You’ll Need in Retirement
This step is tricky because you are estimating expense levels for a life you are not yet living. Many financial planners recommend using 80% of your current income as a yardstick in order to make it simple for you.
We’ll use a hypothetical figure and timeframe for this article. So in this case, let’s assume an income of $10,000 per month, which at 80% is $8,000, or $96,000 per year.
Step 2: Subtract Social Security and Pension Benefits
You can find this information in your Social Security Earnings Record (viewable on the agency’s website) 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 assume monthly Social Security and pension income will be $4,000 per month. This reduces the income needed at retirement to $4,000 per month, or $48,000 per year.
Step 3: Factor in Time Horizons
There are three numbers you should be concerned with here:
Your current age
Your expected retirement age
The number of years you expect to live after you leave work
You can use life expectancy charts to determine how long you can expect 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, a retirement age of 65, and that you’ll live as a retiree for 20 years.
About one-third of American workers say they’re saving less than 5% of their salaries for retirement.
Step 4: Determine the Return on Your Retirement Assets
Of course, there is no way to precisely calculate the return on investment (ROI) for your savings, 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, your investments will be relatively conservative. For our example, we assume an ROI of 8% until retirement, and 5% after that.
Step 5: Account for Inflation
It is a good idea to account for inflation as it can have a major effect on the outcome of your plans. For our example, we assume a 3% inflation rate.
Step 6: Put It All Together
Here’s what we have so far:
Required yearly retirement income:$48,000Current age, 35, retirement age, 65, and 20 years in retirementRate of return of 8% before retirement and 5% during retirementAn annual expected inflation rate of 3%
You can use an online calculator to do the math. Using the figures from our example, you will need to accumulate approximately $1.97 million to retire at age 65 with 80% of your current income.
Now you have a goal to aim for with your retirement investments: $1.97 million. When you make contributions, you will know how close you are to reaching your goal.
Saving for retirement can seem like a daunting task. You have to be incredibly disciplined with your savings month after month, and year after year, until you hit retirement age. You also need the willpower to avoid jumping into hot stocks or risky sectors of the market and, instead, continue to maintain your portfolio diversification.
As difficult as saving for retirement can be, you can use compound interest as a way to help you achieve your goals while you save for your retirement.
Planning to never retire is not a realistic plan because you may be forced into retirement unexpectedly.
Your Retirement Ally: Compound Interest
Even if you contribute the maximum amount to your Roth IRA and are incredibly disciplined in doing so year after year, your contributions alone will not be enough to build that retirement nest egg. That’s why compound interest is so important.
Compound interest is the interest that accrues on your contributions and the accumulated interest of that principal. In short, it’s interest on the interest you’ve earned in the past. Compounding interest allows an invested sum to grow at a faster rate than simple interest, which is calculated on the principal alone.
Compound Interest for Retirement Accounts
Let’s look at an example using $12,000 in annual contributions (we assume that you and your spouse each contribute $6,000 a year to a Roth IRA as a lump sum at the beginning of each year). If your $12,000 deposit earns 8%, the simple interest for that year would be $960. Your accounts would collectively end the year at $12,960 ($12,000 + 960). A the end of the next year, the combined balance would be $25,920 ($24,000 * 1.08) because you only earn interest on contributions.
Let’s say your Roth IRA accounts earn interest at an 8% compounded rate instead. At the end of the first year, you would have the same balance as if you earned simple interest: $12,960. But at the end of the second year, you would have $26,957 instead of $25,920 because of the extra interest you’ve earned on the first year’s interest ($12,000 + 12,960 = $24,960 * 1.08 = $26,957). It may not be a huge difference yet, but still, more than the simple interest would earn.
Of course, the more years that pass, the greater the effect of compounding. Below, we list the total profit accrued over each subsequent year;
Year 1: $960Year 2: $2,957Year 3: $6,073Year 4: $10,399Year 5: $16,031
The Long-Term Impact of Compound Interest
Your account growth suddenly exceeds your annual contributions in the fifth year. As your account continues to grow, that increase gets greater and greater, 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.
Your contributions will exceed what you put into the account on an annual basis over time. But just because your account grows more than $12,000 in a given year doesn’t mean you should stop making contributions. A key component of growth is having a large contribution base. So stay dedicated and keep funding the account every year (to the maximum amount if possible).
Develop a Well-Rounded Investment Plan
Will a Roth IRA be sufficient for you to build your $1.97 million nest egg? Probably not, since you can only contribute up to $6,000 a year, or $7,000 if you’re over 50, which are the contribution maximums for 2021 and 2022. Although the IRS periodically adjusts them for inflation, it gives you a sense of the general ballpark.
Roth Income Limitations
The Roth IRA has income limitations, which means you may not be able to contribute to a Roth if you earn over the limit. If this is the case, your contributions could be limited or phased out entirely. The phased-out income limitations also depend on your tax filing status.
You cannot contribute to a Roth IRA in 2021 if you’re a single filer and earn more than $140,000. The income phase-out range for contributions is $125,000 to $140,000. That range increases to between $129,000 and $144,000 in 2022, which means you can’t contribute if you earn more than $144,000.
For married couples who file a joint tax return, the Roth income phase-out range, it’s $198,000 to $208,000 in 2021 and $204,000 to $214,000 in 2022.In other words, if you make more than $208,000 in 2021 and $214,000 in 2022 as a married couple filing jointly, you can’t contribute to a Roth.
A Roth IRA has valuable tax advantages such as tax-free withdrawals in retirement and no required minimum distributions (RMDs). But this is only one part of a well-rounded retirement savings plan. If you have a 401(k) with your employer, that is another good option, particularly if your employer offers matching contributions.
You only get one shot at retirement planning, so it can be helpful to work with a qualified financial planner or advisor. An advisor will help you set goals for retirement and develop a plan to reach them.
What Is the Best Way to Fund a Roth IRA?
The best way to fund your Roth IRA is to invest the maximum amount permitted each year. It’s a bad idea to withdraw funds, incurring penalties and taxes, if you withdraw the earnings before age 59-1/2 and before the funds have been in the account for five years. (Your contributions can be withdrawn at any time, penalty-free.) This strategy allows you to benefit from compound interest—or interest that is accrued on the interest previously earned. This results in higher earnings than simple interest.
Should I Contribute the Maximum Even When Market Prices Are High?
Generally speaking, yes. Even if you think stock funds are overpriced, it’s generally worth making the maximum contributions to your Roth IRA. The money will grow tax-free, and the tax savings you will eventually realize are likely to be far larger than the slightly inflated cost of stocks, shares, and funds.
Can You Get Rich From Compound Interest?
Yes. In fact, compound interest is arguably the most powerful force for generating wealth ever conceived. There are records of merchants, lenders, and various businesspeople using compound interest to become rich for literally thousands of years. Warren Buffett, more recently, became one of the richest people in the world through a business strategy that involved diligently and patiently compounding his investment returns over long periods of time.
How Does the 5-Year Rule Work?
The Roth IRA five-year rule states that you cannot withdraw earnings tax free until at least five years since you first contributed to a Roth IRA. This rule applies to everyone who contributes to a Roth IRA, whether they’re 59½ or 105 years old.
The Bottom Line
The benefit of compound interest is a great advantage, especially if you begin your savings and retirement plan early in your career. Being disciplined about the purpose of these savings and not making early withdrawals that can incur penalties and fines will help you reach your goals and provide a better retirement for you.
Researching what costs you will need to cover after you stop working (rent, health care, incidental expenses, taxes, emergencies) can give you a realistic idea of how much you should be saving in order to reach a comfortable retirement lifestyle.
Starting savings early is your “magical” way of self-funding your IRA account. Compound interest over the long term will help grow your retirement savings.