How does a Roth IRA grow & earn interest?

A Roth IRA can help provide individuals with a smart way to grow their savings for retirement and provide tax-free income for the future. Many account owners ask the question, “How can a Roth IRA grow?” The return individuals can see on a Roth IRA account will depend on the investments they put into it. 

Roth IRA

The main characteristic of a Roth IRA is how contributions are taxed. Contributions to traditional IRAs are done with pre-tax dollars. The account owner will pay income tax when they withdraw the money. Alternatively, Roth IRA contributions are made with post-tax funds. Individuals can withdraw their contributions and any earnings tax-free at their discretion after owning the account for five or more years, as long as they are 59 1/2 or older. 

How a Roth IRA can earn interest

A Roth IRA can increase its value over time by compounding interest. Whenever investments earn interest or dividends, that amount gets added to the account balance. Account owners then can earn interest on the additional interest and dividends, a process that can continue over and over. The money in the account can continue to grow even without the owner making regular contributions. 

Unlike traditional savings accounts that have their own interest rates that periodically adjust, Roth IRA interest and the returns account owners can earn depend on the portfolio of investments. Many factors determine how a portfolio grows with Roth IRAs, including the risk tolerance of the owner, their timeline for retiring, and their portfolio’s diversification¹. 

Hypothetically, let’s say you invest $5,000 annually for 15 years from age 35 to 50 with an average annual return of 7%. Assuming the compounding occurs annually, while your total amount invested would be $75,000, your total balance could be $346,659 thanks to compound interest. Please note that this example does not take into account the impact of fees, taxes and other charges, which would further reduce returns. However, if you were to park that same amount of money in a traditional savings account with no interest, you’d have only $75,000 after 15 years.

How experts say you can maximize Roth IRA returns

Where investors decide to open a Roth IRA can have a significant impact on the investments they select and the potential returns from those investments. For example, traditional banks may only offer a certificate of deposit Roth IRA which may have lower rates of return. 

For the largest array of investment options, individuals can open a Roth IRA with a brokerage firm. Brokers allow you to select your investments based on your risk tolerance, financial objectives, and any other considerations you may have. Types of investments can include (but are not limited to) a mix of exchange-traded funds (ETFs), index funds, stocks, and bonds. 

Opening a Roth IRA

There are no federal regulations regarding the minimum contribution needed to open a Roth IRA. Every robo-advisor, bank, and brokerage firm has its own set of requirements regarding how much is needed when opening an account with them.  

However, individuals seeking a Roth IRA account need to be aware of maximum income and contribution limits and be sure to follow them. Contribution limits usually increase over time, so it’s important to watch for annual updates. For 2023, the maximum contribution amount for individuals is $6,500 or $7,500 if you're age 50 or older.

No required minimum distributions (RMDs) for Roth IRAs

A traditional IRA has a required minimum distribution (RMD) account owners must take when they reach a certain age, even if they don’t need the money. The SECURE Act pushed this age from 70 1/2 to 72 years old. 

This isn’t the case with Roth IRAs. Account owners can leave their savings in their accounts for as long as they are alive. They can also continue contributing to it as long as their modified adjusted gross income is below the annual limit and they have qualifying earned income. 

With no RMDs, Roth IRAs are one way to help transfer wealth. When a beneficiary inherits a Roth IRA, they will most likely have to start taking distributions. For this reason, Roth IRAs can help provide years of tax-free income and growth for beneficiaries.

Roth IRA vs. Traditional IRA

The income level, retirement savings strategy, and the anticipated tax rate at the time of retirement of an account owner will help determine if a traditional or Roth IRA is more beneficial. Individuals expecting to be in a higher tax bracket when they retire may often find a Roth IRA more attractive since the tax they can avoid in retirement will most likely be more than the income tax they are paying currently. 

Lower-income and younger workers can most likely benefit the most from the Roth IRA. When they start saving with a Roth IRA earlier in life they can make the most of compounding interest. Even with an anticipated lower tax rate later in life, they can enjoy a tax-free stream of income from their Roth. Individuals not needing assets from their Roth IRA during retirement can let the money stay in the account, which allows the potential to accrue interest indefinitely. 

Highly paid employees and top executives who normally cannot take advantage of contributing directly to a Roth IRA (due to income limitations) may be able to defer Roth contributions into their employer’s 401(k) plan if the plan allows. Once meeting a distributable event from the employer’s 401(k) plan, these individuals may roll their Roth 401(k) account into a Roth IRA without dealing with tax consequences and eliminate any future required RMDs. There are IRA contribution and deduction limits based on your modified adjusted gross income. 

Knowing how a Roth IRA can grow is an important part of deciding if this form of investing may be a good match for your needs. Human Interest can help answer your questions about retirement savings.