How Does a Roth IRA Grow & Earn Interest?

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Traditionally, retirement savings accounts like a 401(k) and IRA (individual Retirement Account) are considered to be the most effective and popular mediums to save for retirement primarily due to the tax advantages offered by these plans. By investing in these accounts, you can contribute pre-tax dollars and earn tax-free returns on your investments. Money withdrawn from these accounts are taxed as per ordinary income tax rates. In addition, you have to adhere to certain restrictions when taking withdrawals, such as a 10% penalty for taking out funds before reaching 59.5 years of age along with the tax charges and more. You are also handicapped by limited investment options, restricting your ability to grow your savings over time. Despite these cons, 401(k) and IRA remain a popular saving instrument for retirees. The US retirement market is worth $37.2 trillion of which 401(k) plans constitute approximately $7.3 trillion making up one-fifth of the market. This is true as of June 30, 2021. If we go back ten years, in 2011, 401(k) assets made up 17% of the US retirement market with an approximate value of $3.1 trillion.

There are a number of factors why retirees feel the pressure to identify different and more beneficial tax-saving vehicles than a 401(k) and an IRA. Increased life span, sharply rising inflation, diminishing interest rates, and heightened retirement savings expectations are contributing factors that retirees have to take into account especially in their early saving years. Herein, one can see the Roth IRA emerging as a popular choice. Through a Roth IRA you can grow your savings without being hampered by the disadvantages of a traditional IRA or a 401(k) plan. In a Roth IRA, you contribute your after-tax dollars and earn tax-free growth on the sum through investment in multiple investment options available to you. What makes Roth IRA a popular investment choice over a basic IRA or a 401(k) is that you can make tax-free withdrawals from a Roth IRA account. Though a Roth IRA and a traditional IRA have some similar aspects, they differ when it comes to income eligibility criteria, withdrawal conditions, and more. Therefore, it would be beneficial for you if you took the time to understand the Roth IRA in detail to be able to create a large retirement corpus to support your ever-evolving retirement living expectations. You can do so by consulting with a financial advisor who can help you assess and understand the pros and cons of a Roth IRA account and create a suitable retirement strategy for you.

Let us find out what you need to know about Roth IRA growth and interest:

What is a Roth IRA?

Roth IRA is an individual retirement account wherein you contribute after-tax dollars and receive tax-free returns on your investments. You can also make tax-free withdrawals provided you meet certain conditions. In layman terms, you pay taxes on your contributions upfront that enables you to harness the power of compounding to get tax-exempt withdrawals during retirement. However, to receive tax-and penalty-free withdrawals from a Roth IRA, you must satisfy a 5-year holding period, and your age must be 59.5 years or more at the time of withdrawal. If you meet both these criteria, the withdrawals are considered qualified allowing you to make tax free withdrawals.

First introduced in 1997, initially Roth IRAs were overlooked in favour of traditional 401(k) plans and IRAs. This has changed considerably over the last few years due to the rising tax rates and an increased focus on saving taxes and boosting retirement savings. Moreover, a self-employed individual can invest in an IRA, including a Roth IRA, to save for their retirement, unlike a 401(k) plan, wherein only private-sector employees can open their accounts.

Further, if you foresee yourself being in a higher tax bracket during retirement, a Roth IRA would be a sound investment vehicle for you. As you will be paying taxes in the present, you would not owe any taxes in the future at the time of withdrawal, considering you take qualified distributions.

What are the contribution limits in a Roth IRA and how many Roth IRAs can you have?

Similar to a 401(k) and a traditional IRA, a Roth IRA also has contribution limitations. For 2022, an individual can contribute up to $6,000 per year in a Roth IRA which goes up to $7,000 annually if you are 50 years or older. Do note that Roth IRA contributions can only come from an earned income i.e. salary, wages, bonus, freelance income, business profits, commission, and other assignment work.

Apart from this, you can hold multiple IRAs; i.e., you can have multiple Roth IRAs, SEP IRAs, and traditional IRAs. However, multiple Roth IRAs come with the same restrictions pertaining to contributions. You can split your money in different Roth IRAs, but it cannot exceed $6,000 and $7,000 (if you are above 50 years) as mandated by the IRS. If you make contributions above the stipulated contribution limit, the IRA will levy a 6% penalty every year until the mistake is corrected. However, these contribution limits are not applicable when you carry out an IRA rollover, where you transfer money from an existing employer retirement plan like a 401(k) into an IRA.

Also, the amount of funds you can contribute to a Roth IRA is also handicapped by income contribution limits and your tax filing status. Which is why it would be in your best interest to be up to date with the Roth IRA contribution limits along with income eligibility and tax filing status.

What are Roth IRA income eligibility rules

Whether or not you are eligible to contribute to a Roth IRA depends on your Modified Adjusted Gross Income (MAGI). Depending on your tax filing status, you can max out your contributions, if your MAGI is less than the contribution limit mandated by the IRS. If your earned income exceeds the IRS-specified MAGI income limits, you cannot contribute your funds to a Roth IRA.

To assess your eligibility for a Roth IRA go through the 2022 Roth IRA table.

Tax Filing Status MAGI Limits Contribution Allowance
Married filing jointly or a qualifying widow (er) Less than $204,000

$6,000

$7,000 if you are above 50 years
Married filing jointly or a qualifying widow (er) More than or equal to $204,000 but less than $214,000 A lower sum than the general limit
Married filing jointly or a qualifying widow (er) More than or equal to $214,000 Ineligible for Roth IRA
Married filing separately and have lived with your spouse at any time during the year Less than $10,000 A lower sum than the general limit
Married filing separately and have lived with your spouse at any time during the year More than or equal to $10,000 Ineligible for Roth IRA
Single, head of household, or married filing separately and have not lived with spouse at any time during the year Less than $129,000

$6,000

$7,000 if you are above 50 years
Single, head of household, or married filing separately and have not lived with spouse at any time during the year More than or equal to $129,000 but less than $144,000 A lower sum than the general limit
Single, head of household, or married filing separately and have not lived with spouse at any time during the year More than or equal to $144,000 Ineligible for Roth IRA

To find out how much you can contribute to a Roth IRA account provided you are eligible to make reduced contributions to it, follow these steps:

  • Take your MAGI and deduct these figures from your MAGI:

    • $204,000, if you are married, filing jointly, or a qualifying widow(er)
    • $0, if you are married, filing separately, and you lived with your spouse any time during the year
    • $129,000, for all other cases

  • Divide the result in the above step by:
    • $10,000, if you are a married and filing jointly, qualified widow (er)
    • $10,000, if you are married and filing separately and you lived with your spouse any time during the year
    • $15,000, for all other cases

  • Multiply the result in the above with the maximum contribution limit - $6,000 or $7,000 (if you are 50 years or older)

  • Subtract the result of the above step from the maximum contribution limit before any reduction.

The answer is the reduced sum you can contribute to a Roth IRA as per your applicable tax status and income eligibility.

How does a Roth IRA grow and what is meant by the Roth IRA return rate?

In a Roth IRA, instead of getting interest, you receive returns. Think of a Roth IRA account as an empty basket wherein the returns you receive from the basket depend on the investments chosen by you to fill that basket. To generate returns, you need to invest your Roth IRA savings in different securities such as stocks, bonds, mutual funds, exchange-traded funds (ETFs), certificates of deposits (CDs), and money market accounts. Compared to a traditional IRA and a 401(k) account, you have access to a wider range of investment options. Do keep in mind that not even a Roth IRA allows you to invest in real estate, cryptocurrency, LLC membership interest, and precious metals. If you wish to invest in these alternate class assets, you can go for a self-directed Roth IRA, which allows you to invest across the aforesaid alternative asset classes and avail the same tax advantages as a Roth IRA.

When it comes to your Roth IRA return rate, it is dependent on the performance of your underlying investments. The dividends and interest generated by your investments is added to your Roth IRA balance. The earnings growth of your Roth IRA depends on the investments it contains. Simply speaking, the securities chosen by you earn interest and dividends which get compounded over time and allows your money to grow faster. You earn interest on the accumulated interest and dividends, the earnings on your investments are added to your Roth IRA balance, and it keeps growing. Even if you stop making regular contributions to your Roth IRA account, your money would keep growing until you withdraw it.

Coming to the Roth IRA return rate, even though there is no fixed return rate, several factors such as portfolio diversification, investment time horizon, risk tolerance, and portfolio composition can impact how your money grows. Historically, the average Roth IRA return has been between 7% and 10%. For instance, if you contribute $6,000 in your Roth IRA for 15 years, and your investments generate an average Roth IRA return of 7%, at the end of 15 years, you would approximately have $151,050 in your Roth account. Alternatively, if you choose to keep your money in a savings account, you will have only $90,000 by the end of the fifteen years ($6,000 *15) as there is no interest or dividend accumulation. The longer you invest your money, the greater is the power of compounding.

Coming to how a Roth IRA grows, go through the following example to understand the concept. Assume,

  • Annual contributions = $4,000
  • Contribution period = 20 years

Say, you have invested $80,000 in your Roth IRA account, and your account earns a modest $5,000 in interest. This brings your Roth IRA balance to $85,000 ($80,000 + $5,000). You invest this sum of $85,000 in a mutual fund scheme that has an average return of 8%. So, after the first year ends, your Roth IRA has $6,400 as simple interest ($80,000 multiplied by 8%) and $400 as compound interest ($5000 multiplied by 8%), bringing your total balance to $91,800. This cycle would repeat itself till the time you do not make a withdrawal from your Roth IRA account. Even if you stop contributing after 20 years, your savings will continue to earn compound interest until you decide to withdraw from your Roth account.

Additionally, there are no RMD (Required Minimum Distribution) restrictions in a Roth IRA meaning unlike in a traditional IRA where you have to take out mandatory RMDs as specified by the IRS when you reach 72 years of age, you do not have to the same when it comes to a Roth IRA. You can leave your funds in your account to accumulate for your lifetime and keep contributing to it indefinitely should you choose to, provided you meet the income eligibility criteria.

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How to maximize Roth IRA returns

Investing in high-return securities like stocks can allow you to maximize your Roth IRA returns however keep in mind that stock investments carry high risk. It is advised to aim to keep your investments for a longer time horizon to counter market volatility. Safe to say that timing plays a crucial role when it comes to maximizing your Roth IRA returns. Moreover, at a younger age, you have a higher risk tolerance, allowing you to invest in high-return securities and for a longer period of time where you can benefit from the power of compounding.

Further, your Roth IRA custodian also plays an important role in maximizing your Roth IRA returns potential. If you open your Roth IRA account with a traditional bank, you have access to limited investment options such as certificates of deposits which pay out a lower rate of return. On the other hand, if you choose to open a Roth IRA through a financial advisor, you have a diverse choice of investment options to choose from that you can pick based on your financial goals and risk appetite. Herein, you can come up with an optimally diversified portfolio made of a composition of stocks, bonds, index funds, mutual funds, and exchange-traded funds (ETFs).

Lastly, to maximize Roth IRA returns, take care to pick an account with the lowest charges, such as account maintenance fees, trading fees or commissions, mutual fund expense ratios, mutual fund loads, etc.

What are the Roth IRA withdrawal rules?

To make tax-free withdrawals from a Roth IRA, you need to fulfill some conditions:

  • You must hold the Roth IRA for at least a period of five years or more.
  • You can withdraw funds from your Roth IRA only after reaching the age of 59.5 years or more.

With that said, if you want to, you can make a withdrawal from your Roth IRA at any age or time without paying any penalties or taxes. But your drawings must comprise only the original contribution. This is so because you paid taxes on the contributions made by you to the Roth IRA and can take the money without any add-on charges. But this rule does not apply on the earnings component taken out from the Roth IRA on which you will have to pay taxes. However, if you adhere with the five-year and 59.5 age rules, you would be able to make tax-free withdrawals inclusive of earnings.

Apart from the withdrawal rules, you must also be aware of the withdrawal structure of your Roth IRA. It is as follows:

  • The first distribution from a Roth IRA comes from your original contributions.
  • The next distribution comes from conversions and Roth rollovers (on first-come-first-go criteria).
  • The final distribution comes from your earnings.

Thus, even though you do not pay any taxes or penalties on the original contributions, you would be liable to pay taxes and penalties on the following distributions if you fail to adhere to the Roth IRA withdrawal rules (non-qualified distributions).

However, you can make non-qualified withdrawals on which you do not have to pay any taxes or penalties in certain instances. For example, if you are buying a home for the first time, you can withdraw a sum of up to $10,000 which is tax-free in nature. This is true even if you are taking out the drawings before 59.5 years or the five-year account holding expiration. There are other instances wherein you can qualify for tax-free withdrawals from a Roth IRA:

  • Post-secondary education fees
  • Permanent disability
  • Health insurance premiums during unemployment
  • 10% of unreimbursed medical costs

To conclude

By assessing and understanding the way a Roth IRA works, and its growth and interest components, you can use this knowledge to create a desirable retirement savings corpus for your future. Roth IRA offers several advantages such as better tax benefits, diverse investment options, flexible withdrawal rules, and not having to pay mandatory RMDs unlike in a traditional IRA or a 401(k) plan. With that said, it would be prudent to consult with a professional financial advisor and create a diversified portfolio with the best Roth IRA investments as per your risk tolerance and financial goals.

To get in touch with a fiduciary advisor who may help you understand the benefits of opening a Roth IRA, how it works, and its growth and interest components, use the free advisor match service. Based on your requirements, the platform scans through registered and qualified advisors to match you with an advisor suited to your needs and goals.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.