Nov 22, 2022

How Compound Interest Increases the Value of a Roth IRA

Today, we discuss how the magic of compounding can really make a difference with your Roth IRA account and if you do not yet have one, this can be a huge incentive for you to start a Roth IRA!

Roth IRAs Explained

How Compound Interest Increases the Value of a Roth IRA

A Roth individual retirement account (Roth IRA) enables you to save for retirement with already-taxed funds. Then, eligible withdrawals from a Roth IRA are tax-free, making it an attractive alternative for retirees who anticipate being in a higher tax bracket. Compound interest can have a big effect on how much your savings for retirement amount to over time. If you start saving with a Roth IRA right away, your money will have more time to grow because of the power of compounding.

Today, we discuss how the magic of compounding can really make a difference with your Roth IRA account, and if you do not yet have one, this can be a huge incentive for you to start a Roth IRA. Let’s first go over the basics.

The Roth IRA Tax Rules & Contributions

A Roth IRA is a retirement account funded with after-tax dollars and allows for qualified tax-free distributions. The Internal Revenue Service (IRS) sets rules for Roth IRAs, such as how much you can put in and how much you can take out. 

Some of the most important tax rules for Roth IRAs are as follows:

  • Contributions are not tax-deductible
  • Qualified distributions, including distributions beginning at age 59 ½, are tax-free
  • Original contributions can be withdrawn at any time without a tax penalty
  • Required minimum distributions (RMDs) do not apply

A certain amount can be put into a Roth IRA each year

For 2022, the most you can put in each year is $6,000. If you are 50 or older, you can put in an extra $1,000. The most you can put into a Roth IRA depends on how much money you make and what kind of tax return you file. 3 For example, if you are married but file separate tax returns, you can't put money into a Roth IRA if your modified AGI is $10,000 or more. 

Roth IRAs have some features that set them apart from traditional IRAs. Here are some differences:

Roth IRA

  • Contributions aren’t tax-deductible.
  • There are no required minimum distributions and no age limits for contributions.
  • Qualified withdrawals are tax-free.
  • Your income determines how much you can contribute toward the annual contribution limit.

Traditional IRA

  • Contributions are typically tax-deductible.
  • Require minimum distributions to be made after age 72.
  • You must pay tax on the deductible contributions you made at the time of withdrawal.
  • Only annual contribution limits apply.

When people consider interest, they frequently consider debt. However, interest can be advantageous when it is earned on savings and investments.

Compound interest is interest calculated on both the initial principle and the accrued interest from prior periods.

Consider it as a cycle of earning "interest on interest," which can quickly snowball wealth. Compound Interest will accelerate the growth of a deposit or loan relative to simple interest, which is calculated just on the principal amount. In addition to receiving interest on your initial investment, you also receive interest on interest! Because of this, your wealth can expand exponentially with compound interest, and the concept of compounding returns is comparable to putting your money to work.

How to Start Investing with $1,000

How Does a Roth IRA Grow?

Generally speaking, the goal of a Roth IRA is to hold investments that grow in value over the course of their ownership of the account. When you start a Roth individual retirement account (IRA), you are not immediately investing money in anything. You are only establishing a "storehouse" for the funds that you intend to invest for your retirement in the future.

How Fast Does a Roth IRA Grow?

How fast a Roth IRA grows can depend on how often you put money into it and how often your investments earn interest and dividends. The more often you put money into your account, the faster it may grow over time.

Note: Any Roth IRA funds not used during your lifetime could be passed on to a beneficiary!

Investments That Are Allowed in a Roth IRA

In addition to simply funding your account, you need to decide how you’re going to invest those funds. 

A Roth IRA offers a wide range of investment possibilities, including mutual funds, equities, bonds, exchange-traded funds (ETFs), certificates of deposit (CDs), money market funds, and even cryptocurrency, once the funds have been contributed. In addition to the standard investments, you can have things that aren't usually part of a retirement portfolio. You can put your money into gold, real estate investments, partnerships, tax liens, and even a franchise business.

Investments That Are NOT Allowed in a Roth IRA

It's important to note that you can't put cryptocurrency into your Roth IRA due to IRS regulations. The IRS also lists other assets not eligible in an IRA, such as life insurance contracts and derivative trading, as well.

Through the Alto CryptoIRA®, you can invest in any digital asset that's supported by the Coinbase exchange (currently over 200 currencies). Alto's direct integration with Coinbase makes it about as easy as possible to invest in crypto through your self-directed IRA.

Note: The recent introduction of "Bitcoin IRAs" has resulted in the creation of retirement accounts that allow you to invest in cryptocurrencies.

Compound Interest and Your Roth IRA

Your investments can make you money over time through interest or dividends. A dividend is a share of a company's profits that it gives to its shareholders. 

With a Roth IRA, you keep getting interest on your account balance as long as you keep adding reinvested interest or reinvested dividends to your principal.

Some investments, like mutual funds, stocks, and exchange-traded funds, could go up in value every year, which would also add to the value of the investment over time. So, as you can see the way you invest can affect how much your money grows over time. If you put your money into investments with a higher level of risk, your returns may be less stable and more likely to change. You might even lose money. Bonds can also have different interest rates and dividends.

The less you have to put into an investment, the higher its average annual return (e.g., 6% vs. 4%). This is compound interest solely working for you! If you want the most investment options, you might want to look into a Roth self-directed IRA (SDIRA), which is a type of Roth IRA where the investor manages their own assets instead of a bank. These give you a whole new set of ways to make money. 

Read more: Should I Diversify My Investments?

The Benefits of Compound Interest for a Roth IRA

Those who are qualified to contribute to a Roth IRA can reap a plethora of tax benefits. Contributions are not tax deductible each year, but withdrawals made after retirement are free of federal income tax. If you don't have to worry about taxes eating into your account growth, you can focus on maximizing the compounding interest generated.

Roth IRAs Explained

No minimum distributions are needed to be taken out from a Roth IRA account either. This Internal Revenue Service regulation mandates that you begin withdrawing funds from your standard IRA at age 72, but does not apply to Roth IRAs. This allows you to let your savings grow tax-free until you actually need the money. Since one of the primary prerequisites for establishing a Roth IRA is earned income, it is possible to continue doing so for many years into retirement.

A Roth IRA Guide

Wrapping Up

Always, Always Prioritize Your Investments for Retirement

It's crucial to know what saving options you have and how they might help you financially when developing a retirement plan. As you can see, starting a Roth IRA has the potential to BUILD an amazing amount of TAX FREE money. Take the next step and begin right now. Even if you are unable to contribute the maximum amount each year, you can still take advantage of the magic of compound interest and tax-free earnings!

Speak with an advisor to get started today.

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