IRAs are a popular investment vehicle for individuals planning for retirement, and Roth IRAs have long been known as one of the most beneficial types of retirement accounts available. With the ability to compound your earnings tax-free, Roth IRAs can grow substantially in value over time if you invest with them properly.
Learn how Roth IRAs work and different strategies to grow your Roth IRA so that you can retire on your own terms.
What Is a Roth IRA?
A Roth IRA is an individual retirement account that is taxed upon contribution but grows tax-free afterward. Since you pay taxes before the funds enter your account, qualifying withdrawals are tax-free (as long as you don’t break any rules).
This is in contrast to a Traditional IRA, which is funded with pre-tax dollars, which means that all withdrawals will be subject to an income tax.
Benefits of a Roth IRA
Roth IRAs offer several benefits to investors, which make them more popular than other accounts, including:
- Tax-free withdrawals. Since Roth IRAs are taxed upon contribution, you won’t need to pay taxes on withdrawals during retirement. This can be beneficial if you think you’ll be in a higher income tax bracket during retirement.
- Tax-free growth. All earnings can compound tax-free, allowing you to take home more at the end of the day.
- No required minimum distributions (RMDs). RMDs refer to a specific amount of money you need to withdraw from your account each year based on an IRS life expectancy factor. Roth IRAs do not have RMDs that Traditional IRAs are subject to. RMDs can force you to remove funds (and earning potential) from your account before you need them.
- Penalty-free early withdrawals from contributions. As long as your Roth IRA account is at least 5 years old, you can withdraw all contributions without penalty, even if it’s before the age of 59 ½. This feature can add flexibility to your financial planning, which is not available in a Traditional IRA.
How Does a Roth IRA Grow Naturally?
IRAs grow naturally, even if you stop contributing to them, thanks to compound interest. Funds in a Roth IRA can be invested in various stocks, mutual funds, bonds, and other investment assets, that can grow and be reinvested into your portfolio without having to pay a portion of your earnings in tax. By simply having more money to reinvest into your account, you can grow your earnings by putting that money to work and earning more on top of that.
Tips to Grow a Roth IRA Over Time
While you can take a set-it-and-forget-it approach to your Roth IRA, there are simple steps you can take to maximize growth and increase earnings over time.
1. Maximize Contributions
Whenever possible, you should contribute up to the IRS maximum contribution amount allowed in a given year. This will allow you to take advantage of compound interest and grow your account substantially more for retirement. If you own a Roth IRA, that means taking into account two factors:
- Base IRA contribution limits. Both Traditional and Roth IRAs share a base contribution limit. The current limit is $7,000 ($8,000 if you’re 50 or older), but can change annually. Always check the latest IRS guidance.
- Roth income-based limits. Roth IRAs are subject to another set of contribution limits based on your income and tax-filing status. Depending on your circumstances during a given tax year, you may be able to contribute the full amount, an adjusted amount, or nothing at all.
2. Invest in Compound Interest Investments.
Certain investments, like stocks and mutual funds, earn compound interest, allowing your account to grow faster, even if you’re not actively contributing to it. Include these types of assets in your account portfolio to create a strong foundation and promote long-term growth. Use this compound interest calculator to project your growth so you can plan for retirement.
3. Set Up a Backdoor Roth IRA if Your Income Exceeds Limits
If your annual income bars you from making direct Roth IRA contributions, you can leverage a backdoor approach to ensure you still have access to Roth benefits. To do so, you can open a Traditional IRA and convert it to a Roth IRA. Keep in mind that the conversion will require you to pay taxes since Traditional IRA contributions are made with pre-tax dollars.
4. Perform Your Due Diligence
Even if your Roth IRA is a managed account, it’s wise to regularly check in on your portfolio to ensure funds are invested in a range of assets that can promote long-term earnings and diversity. This, when paired with market and industry awareness, can help you adapt your retirement strategy to meet your needs in the context of economic growth trends.
5. Self-Direct Your Account
Standard Roth IRAs limit your investment options to assets traded on the open market, like stocks, mutual funds, and ETFs. These can serve as a good foundation for a portfolio, but they prevent you from truly diversifying your account.
To gain access to a wider range of assets, consider opening a self-directed Roth IRA. Self-directed IRAs (SDIRAs) allow you to invest in alternative assets, such as real estate, private equity, and promissory notes, many of which offer higher earning potential.
How to Open a Roth SDIRA
Opening a Roth SDIRA is easy. Just follow these steps:
1. Choose a custodian. All SDIRA accounts must be held by an IRS-approved custodian. Though many banks, credit unions, and other financial entities offer standard IRA accounts, few offer true SDIRAs.
To choose the right custodian, look for one that is approved by the IRS and specializes in the alternative asset(s) of your choice. They will better understand the intricacies, requirements, and administrative tasks associated with that type of investment, setting you up for success.
2. Open and fund your account. Once you choose a custodian, complete the new account paperwork and choose how to fund your account. Generally, you can fund the account by rolling over or transferring funds from one account to another or by making a direct contribution, such as from your checking account.
3. Select your investments and complete due diligence. With funds in the account, you can begin to invest in the asset(s) of your choice. Note that this requires due diligence on your part, as you have ultimate control over your account. SDIRA custodians do not offer investment advice or otherwise manage your decisions.
There’s a reason so many investors choose Roth IRAs to grow their wealth and retire early. If you are interested in opening a Roth SDIRA to plan for retirement, contact one of our concierge team members at Horizon Trust to set up an appointment.
FAQ
How does compound interest work within a Roth IRA, and how can it maximize growth?
Compound interest in a Roth IRA account works by levering earnings to invest. Earnings from those new investments are then reinvested, maintaining a cycle of investment and growth. You can maximize growth by:
- Making annual contributions up to your limit.
- Ensuring that your portfolio includes assets that earn compound interest, such as mutual funds and stocks.
- Maintaining investments for the long term to allow for ongoing compound interest growth.
How can an investor maximize their contributions to a Roth IRA each year?
You can maximize your contributions by:
- Identifying the maximum annual contribution each year and ensuring you contribute up to the maximum allowed.
- Taking advantage of the annual catch-up contribution once you reach age 50.
- Regularly monitoring your contribution strategy to ensure that it’s aligned with your goals and IRS requirements.
- Including a healthy mix of dividends and interesting earning assets to benefit from compound interest.
What are the advantages of investing in dividend-paying stocks within a Roth IRA?
By holding dividend-paying stocks in a Roth IRA, you can earn compound interest when the dividends are reinvested. This can create ongoing growth that steadily builds wealth over time. In addition, dividend-earning stocks may offer more stability when compared to other assets and may help create a steady stream of income later in life.
