LAST REVIEWED May 01 2020 8 MIN READ
By The Human Interest Team
A Roth IRA provides 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 does a Roth IRA grow?” The return individuals see on a Roth IRA account will depend on the investments they put into it.
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. Alternately, Roth IRA contributions are done 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 Earns Interest
A Roth IRA increases its value over time by compounding interest. Whenever investments earn interest or dividends, that amount gets added to the account balance. Account owners then earn interest on the additional interest and dividends, a process that continues over and over. The money in the account continues 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 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 diversification. Typically, Roth IRAs see average annual returns of 7-10%.
For example, if you’re under 50 and you’ve just opened a Roth IRA, $6,000 in contributions each year for 10 years with a 7% interest rate would amass $83,095. Wait another 30 years and the account will grow to more than $500,000. On the other hand, if you elect to keep the same money in a traditional savings account with no interest you’d only have $60,000 after 10 years.
How Experts Say You Can Maximize Your Roth IRA Returns
Where investors decide to open a Roth IRA can have a significant impact on the investments they select and the returns from those investments. For example, traditional banks may only offer a certificate of deposit Roth IRAs which usually have lower rates of return.
For the largest array of investment options, many individuals open a Roth IRA with a brokerage firm. Brokers allow you to select your investments based on your risk tolerance and financial objectives. Types of investments can include a mix of exchange-traded funds (ETFs), index funds, stocks, and bonds.
Opening a Roth IRA
There are no federal regulations regarding a 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 2020 and 2019, the maximum contribution amount for individuals under the age of 50 is $6,000. In 2018, the contribution limit was $5,500.
No Required Minimum Distributions 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 account 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 transfer wealth. When a beneficiary inherits a Roth IRA, they will most likely have to start taking distributions. For this reason, Roth IRAs can 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 determine if a traditional or Roth IRA is more beneficial. Individuals expecting to be in a higher tax bracket when they retire 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 will 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 the snowball effect of compounding interest. Even with an anticipated lower tax rate later in life, they’ll be enjoying 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, continuing to indefinitely accrue interest.
Beneficiaries of traditional IRAs will pay taxes on distributions. Some investors convert or open Roth IRAs fearing a future tax increase. The Roth IRA allows them to lock in the current tax rate on conversion balances.
Even highly paid employees and top executives can contribute to Roth retirement plans via their employers with plans such as the Roth 401(k). These individuals can roll this type of plan into a Roth IRA without dealing with tax consequences and eliminate required RMD when they turn 72.
Knowing how a Roth IRA grows is an important part of deciding whether this form of investing is a good match for your needs. The retirement savings experts at Human Interest can help answer any questions about retirement savings.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.