Importance of a Roth IRA and Compound Interest

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Updated: June 15, 2020

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Disclaimer

In this article, I will cover the importance of a Roth IRA and compound interest, and how you can use a Roth IRA to become a millionaire while sheltering yourself from the Internal Revenue System (IRS).

This does not mean dodging phone calls, creating offshore accounts, or doing something illegal. It's as simple as opening an account called a Roth IRA, which is one of the most powerful income generating tools you have available to you as an investor.

A Roth IRA has also become increasingly important with the uncertain fate of Social Security and the shift away from corporate pension plans, among other things. Our financial foundation in retirement is therefore becoming increasingly dependent on our decisions as individuals.

But before delving into the details of a Roth IRA and why it's so advantageous, it's crucial that we understand compound interest.

Compound Interest Explained

If you start preparing for retirement while you're still young, it's going to take a lot less money to get you to a safe and secure retirement with over $1 million. This is due to what is called "compound interest."

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

- Albert Einstein

Albert Einstein called compound interest the "8th wonder of the world," and for good reason.

Compound interest refers to the concept of your interest accruing interest and is one of the strongest forces at play in investing.

So if you use compound interest to your advantage with your investments, it will definitely make a huge difference over the long term.

Compounding Effect Example

The compounding effect allows one to experience exponential growth with anything that has a continual percentage growth.

So, if you invested $1000 in the stock market, such as in an ETF that follows the S&P 500, and it grew 10% every year, a realistic growth percentage, your $1000 would turn into $1100 by the end of the year.

Instead of taking your $100 profit out of the stock market, you would leave it in the stock market, and experience another 10% growth the next year. This $1100 now becomes $1210. In total, you've made $210 in two years (and $110 in the second year).

In ten years, with a consistent 10% return, you would have $2,593.74, assuming no additional investments or dividends whatsoever!

You can try this for yourself using a compound interest calculator and see the visualization below as well:

Now, while this might not seem worthy of the kind of applause that Einstein gave, when you take this phenomena and expand it to a larger scale, it becomes much easier to see where he was coming from.

The two primary ingredients of compound interest are time and money. When you add more of either of these ingredients, the effect of compound interest is magnified.

In short, every single year you continue to hold the profits you earn, the more your initial investment will grow, for no additional cost to you. Furthermore, the more you invest into the stock market, the more your investment has to compound and grow.

Granted, the stock market will likely not go up 10% each year, sometimes it may go even higher and other times it will be in the negatives. Fortunately, the stock market in the past has more years of growth than it has of loss.

You can see this in the chart below, produced by First Trust Portfolios (with market data from Morningstar).

history of U.S bear and bull markets since 1926

So, now you've got the first piece of the puzzle to retiring a millionaire down: compound interest.

Now, what exactly is a Roth IRA, how does it work, and why should you invest in this retirement account?

Introduction to Roth IRA

A Roth IRA is a type of investment account that can potentially provide you with millions of dollars at retirement, all 100% tax free!

Many people confuse this account with the 401k, which is also a useful retirement tool associated with your employer. You can have both a 401k and a Roth IRA. In most cases, it makes sense to have both.

The Roth IRA is funded with post-tax income while the 401k is funded with pre-tax income. With the 401k, you're taxed on the growth on the way out. On the other hand, with the Roth IRA, you are taxed on the contributions on the way in.

You can withdraw your contributions from a Roth IRA at any time penalty-free and tax-free. You just can't touch the earnings! A Roth IRA is for delayed gratification, whereas a 401k is more for instant gratification. Both have unique benefits that savvy investors can take advantage of.

It's also important to not confuse a Roth IRA with traditional brokerage accounts. For traditional brokerage accounts, you will deposit taxed income into your brokerage and pay taxes once more on any capital gains (including dividends) earned after selling any investments.

Currently, the majority of Americans fall in the 15% tax bracket for capital gains. This means that if you had $1,000,000 in capital gains held in a traditional brokerage account, you'd owe $150,000 in taxes!

With a Roth IRA, you'd owe $0 on those capital gains, which is why Roth IRA's are so important to have. Moreover, you would not have to worry about the significant tax bill that would follow.

These Roth IRA benefits, and more, are listed below:

  • Tax-free retirement income
  • No required minimum distributions
  • High income loophole: "backdoor Roth"
  • Access to contributions if needed without consequences (unlike 401k plans)
  • $10,000 in earnings can go towards first home purchase

Roth IRA Restrictions

Clearly, the tax-free gains you can earn in a Roth IRA make it a highly beneficial tool for individuals looking to secure a safe retirement.

However, if the government is providing an avenue for you to pay less in taxes, it will surely have some strict rules and regulations about what you can and cannot do with you Roth IRA.

Below are the three main restrictions for Roth IRA's.

Restriction #1: Annual Contribution Limit

The first major restriction that a Roth IRA presents is the yearly contribution limit. As of 2020, the annual contribution limit to a Roth IRA is $6000 (or $7000 if you are 50 or older).

This means that after you have deposited $6000 into your Roth IRA, you will not be allowed to make another deposit until the start of the next year.

Any additional capital you wanted to invest would need to be deposited into a traditional brokerage account and would not receive the same tax-advantaged treatment of a Roth IRA.

Restriction #2: You Cannot Withdraw Gains

Potentially the most significant restriction of Roth IRA's is that you are not allowed to withdraw any of your gains until the age of 59.5.

If you withdraw any of your earnings (the gains beyond your deposits) before the age of 59.5, the distributions you withdraw will be taxed as ordinary income and a 10% penalty may be applied. This is definitely not something that you want to be doing if you don't have to.

A common misconception that many people have about Roth IRAs is that this restriction means that they are not able to withdraw any of the money they put into the account until they are 59.5.

Again, this is not the case, and this rule only applies to the earnings you receive from your investments. So, you are free to withdraw any deposits that you have made into your Roth IRA at any point without taxes or penalty.

Restriction #3: Income Threshold Limitations

The final major restriction of Roth IRAs is that once you move beyond a certain income threshold you are no longer eligible to make deposits into your Roth IRA.

For 2020, if you make more than $139,000 as a single person or $206,000 as a married couple, you are not eligible to contribute to a Roth IRA. This income has to be earned income, which essentially means income one earns from a job.

Fortunately, there is a workaround to have a Roth IRA called the "backdoor Roth IRA strategy." What you essentially do here is open a Traditional IRA and convert it to a Roth IRA. You can also rollover a Traditional IRA or 401k into a Roth IRA if this a route you want to go.

This income cap is another reason why Roth IRAs are great for young people. When you are ~20, you are likely not making over $139,000 per year and are perfectly free to contribute to a Roth IRA and start building your foundation for retirement early on.

The $5-a-Day Strategy

Now that you understand compound interest and Roth IRA's, we can combine both of these finance concepts together to create the $5-a-day strategy, which is geared towards those who may not have as much income.

The $5 a day strategy is really simple. Every day, you deposit $5 into your Roth IRA, or just one big $150 deposit once a month to save yourself time. You then invest the balance of your Roth IRA into low-cost S&P 500 index funds.

After a full year, you would have deposited a full $1825 (365 x $5) into your Roth IRA. Assuming an 8% rate of return (the low average return of the stock market), after 50 years you'd have over $1.1 million in your Roth IRA awaiting your retirement (after you turn 59.5 years old).

Now, before you lose interest in this strategy after hearing the timeline required to achieve it, remember the two ingredients of compound interest: time and money.

The $5-a-day strategy relies more heavily on the time side of the equation in order to make it more accessible to anyone.

So, if you instead wanted to achieve a seven figure retirement in a shorter amount of time, all you need to do is increase the $5 amount to $10 or $20, or invest up to the annual contribution limit, as mentioned before, and you'll be able to nearly cut the amount of time required by half.

The Best Allocation Strategy (For Most People)

In MOST cases, this strategy makes sense for your investing plan. This is assuming that you already have your emergency fund in place.

  1. Contribute the maximum to your 401k that your employer will match: If your company offers a match, this is literally free money, so you should take it.
  2. Maximize contributions to a Roth IRA: For 2020, it's $6000. If you're over the age of 50 it's $7000 in a catch-up period. Every couple of years they have been increasing this contribution limit.
  3. Put the excess money in a taxable brokerage account: You can also go with a Traditional IRA account or a different retirement account. It all depends on when you're planning on using this money.

When in doubt, sit down with a financial advisor! You can find a fee-only financial advisor who is not making any commissions from your investments.

Best Strategy Example

Imagine that you pay $3000 a month for living expenses. Furthermore, your employer matches your 401k contributions $0.50 on the dollar up to 6%. At this job, you earn $50,000 a year.

Here's an example on how much you can be contributing and in which order given these measures:

  1. $18,000: High yield online savings account.
  2. $3,000/yr: 401k contribution (Company gives an additional $1500).
  3. $6000/yr: Roth IRA contribution.
  4. $2500/yr: Taxable brokerage.

Now, start investing in your Roth IRA today and you will thank yourself later!

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