A Roth IRA three different growth components:
- Dividends and interest
- Tax-free compounding
Let’s go through each one below.
Growth component #1: Your contributions
The first way your Roth IRA grows is when you make annual contributions to your account. With a Roth IRA, you’re allowed to contribute up to $6,500 for 2023, or up to $7,500 if you’re at least 50 years of age.
The annual contribution limits for the Roth IRA are shared with the traditional IRA. Your combined contributions to both accounts must not exceed the IRA contribution limit of $6,500 for 2023, or $7,500 if age 50+. For example, if you’re under 50 years of age, and contribute $5,000 for 2023 into your traditional IRA, you’ll only have $1,500 in room left over to contribute to your Roth IRA.
Although contribution limits increase each year, adjusting for inflation, the IRA limits are the lowest out of any retirement plan. In comparison, an employee receiving a 401k from their workplace can contribute up to $22,500 ($30,000 if age 50+) for 2023. And a retirement account like the solo 401k and SEP IRA have contribution limits of $66,000 for 2023.
Although the contribution limits of a Roth IRA are lower than others, it’s easier to open an account since there are less restrictions, and no minimum age requirements. Anyone with earned income can contribute to a Roth IRA, even minors can start contributing at an early age through the use of a custodial Roth IRA.
This is extra beneficial because contributions only make for a minor portion of the Roth IRA’s overall growth. The exponential growth comes from tax-free compounding. But before we talk about tax-free compounding, let’s go through #2 on our list, dividends and interest.
Growth component #2: Dividends and interest
Unlike a high-interest savings account, the Roth IRA doesn’t actually earn any interest on its own. In order to earn interest in your account, you have to invest your contribution funds into assets.
After you make contributions into your Roth IRA, the money then gets invested through your account. With a regular Roth IRA, you can invest in a wide variety of traditional asset classes including stocks, mutual funds, bonds, and ETFs. As the account holder, you get to decide what assets to invest your funds in.
What is the average rate of return for a Roth IRA?
The actual rate of return varies depending on what you invest in. Some people will choose to invest conservatively in bonds and mutual funds, while others may decide to take bigger risks and invest in individual stocks.
Historically, a diversified portfolio usually returns between 7% to 10% annually.
However, there are also self-directed Roth IRAs that you can open to invest your Roth IRA funds into alternative investments like crypto, real estate, and even private equity. These are higher risk investments but can have the potential to provide higher returns. Therefore, the rate of return is entirely dependent on your risk tolerance and investment choices.
Growth component #3: Tax-free compounding
The biggest growth component of a Roth IRA is the power of tax-free compounding. When you make a profit and earn interest on your investments, you don’t have to pay any capital gains tax on your earnings. Instead, 100% of the earnings go straight back into your account where it can get reinvested. This puts the power of compound interest into play, and it works on autopilot each year, even years when you don’t make any new contributions to your account.
For example, let’s pretend in the first year of opening your Roth IRA, you contribute $5,000 into your account. By the next year, your account grows by 10%, earning you $500 in interest. Instead of having to pay capital gains tax on the $500 in earnings, the entire amount goes straight back into your Roth IRA where it can get reinvested, giving you a total value of $5,500 to reinvest for the next year.
Now, you can reinvest $5,500 and earn interest on $5,500 for the next year. If you earn another 10% by the following year, your interest earned will be $550, which would again go straight back into your account giving you $6,050 to reinvest the next year. If you make another contribution of $5,000 for the year, you’ll have $11,050 to reinvest, where the 10% interest will now earn you $1,105. This is the power of tax-free compounding and it results in exponential growth for your retirement savings portfolio.
Other growth factors of a Roth IRA
In addition to the three growth components of a Roth IRA, there are several other features that can help you grow your account assets even further.
No required minimum distributions (RMD)
Other retirement accounts have required minimum distributions, where you’re required to start taking distributions from your account once you reach the age of 73. A Roth IRA is unique in that it has no RMD rules. You’re allowed to keep compounding your money as long as you’re alive.
No minimum age requirement
There’s no minimum age requirement with a Roth IRA. As mentioned above, the power of tax-free compounding provides the most growth for a Roth IRA. Children can start compounding their money years or even decades earlier through a custodial IRA, which is established by a minor by a custodian, which is usually a parent, guardian, or another responsible adult. The custodian manages the account and makes all investment decisions for the account. After the child reaches the age of majority, the account ownership gets transferred over to them.
No taxes on withdrawals
With a traditional pre-tax IRA, your withdrawals in retirement get taxed as regular income. With a Roth IRA, withdrawals in retirement are completely tax-free, no matter how large the gains may be. While this doesn’t contribute to the growth of an IRA, it lets you keep more of your money in retirement compared to a traditional pre-tax retirement account.
Also read: Benefits & Tax Advantages of a Roth IRA