If you have an IRA (individual retirement account), you can make $30,000 to $300,000 more over 20 years and $150,000 to $2 million more over 30 years, depending on your annual return rates. And that’s without investing an extra cent … or putting in extra work … or taking on additional risk
Why, then, doesn’t everyone who qualifies have one?
To find the answer, I did an informal poll around the office. Of the 13 people I talked to, only three had IRAs. And not one of the three came close to maxing it out.
Generally, the younger people claimed poverty and the older people claimed their 401(k)s did the trick. Some comments were:
Tommy: “I’ve got a 401(k). Besides, I thought IRAs were only for businesses.”
Skeeter: “I haven’t had time to look into it.”
Joseph: “I have one, but I’ve skipped [making contributions] some years. I want investments that are more short-term and more liquid.”
Don: “I’m too young. I’d rather have the money to spend now.”
Mohini: “IRAs? What are they?”
Julia: “I have a 401(k) and don’t get paid enough to have an IRA too.”
Chris: “I’d rather trade stuff on my own.”
Monica: “I have absolutely no savings.”
The poll results surprised me and the comments surprised me more. Only a couple of my colleagues knew what IRAs were and their knowledge was sketchy at best.
They didn’t realize that IRAs generate extra savings.
Nor did they understand how easy they are. Your broker will set one up for you in half a minute.
And my young colleagues had no idea that if they start with one now – in their early-to-mid 20’s – by the time they’re 55, they can retire with a million bucks in the bank.
By allowing earnings to accumulate tax-deferred, IRAs make your investment grow faster. I’ll give you an example. A 7% return on an investment that is taxed is the equivalent of a 9% return on an investment in an IRA account, assuming you’re in the 28% tax bracket. If you’re in the 33% tax bracket, it’s the equivalent of 9.3%. That doesn’t seem like much. But over a lengthy period, it can make a big difference.
IRAs come in two basic flavors:
Traditional IRAs: If you earn less than $55,000 (or $75,000 for a couple) in modified adjusted gross income (MAGI), you’re eligible for this IRA. You can deduct your yearly contribution from your reported income and pay taxes only when you cash out your account during your retirement years.
Roth IRAs: If you earn less than $110,000 (or $160,000 for a couple), you’re eligible for this IRA. It offers the same tax-deferred earnings as a traditional IRA. The difference is that you don’t pay income taxes on the withdrawals you make from the account when you’re in retirement. However, unlike the traditional IRA, your contribution is not deductible from current income.
If you make too much money to contribute to a Roth IRA, you can still make nondeductible contributions to a traditional IRA.
The tax savings of the two types of IRA are exactly the same if you remain in the same tax bracket before and after retirement. But if you expect to be in a higher tax bracket during your retirement years, the Roth IRA is your better choice. If you expect to be in a lower tax bracket during those years, the traditional IRA makes the most sense.
The amount you ultimately make on your IRA is a function of (1) how much you put in every year, (2) how many years you invest, and (3) the average annual return of your investment.
People typically sweat that last category. But it’s more important to take care of the first two. To get the most out of your IRA savings, put in the maximum amount every year. For 2004, that’s $3,000 if you’re under 50 and $3,500 if you’re over. (You have until April 15th to make your 2004 IRA contribution.) In 2005, the maximum contribution goes up to $4,000 for the under-50 crowd and $4,500 for those over 50.
It’s impossible to say how much you’ll make by maxing out your IRA without knowing the two remaining criteria – rate of return and the number of years you will have invested. But let’s assume an earnings rate of 20%. (That’s what I expect to generate with the stock picks in my new newsletter, The Skeptical Investor.) I’ll also compute a 10% rate – and show you all the numbers for 10, 20, 30, and 40 years.
Give it enough time and an IRA can make you into a millionaire. As you can see from the tables below, at a 20% average annual rate of return, you can easily break the million-dollar barrier in 30 years. But at a10% return, you’ll need a full 40 years to reach a million.
To make sure you get the most out of your IRA, follow these five guidelines
1. The earlier you start, the better. From your first job on, you should be making automatic monthly contributions to an IRA account. It’s hard at the beginning, especially if, like many young people, you’re chronically short of cash. But it’ll pay off big-time for you down the road.
2. If you’re under 40, there’s no reason why you can’t make IRA contributions over at least a 30-year period. With a traditional IRA, you have to begin your withdrawals by the age of 70 1/2. But a Roth IRA has no such restrictions. You can make contributions up until the day you die. So you can start even later and still get in 30 years.
3. If you’re over 40 or 45, don’t panic. If you didn’t already start your IRA, swallow hard and move on. Even in just 20 years, an IRA growing at a 20% yearly clip will net you well over half a million.
4. Go with a Roth IRA unless tax considerations argue otherwise. You can start withdrawing earnings from your Roth account only five years after you start it – as long as you’re 59 1/2 or disabled or using the money to pay qualified expenses for your first home. You can also withdraw the principle at any time without penalty.
5. Treat your IRA savings exactly as you would treat your other investments. You don’t want to put your money into anything so risky that it could “go magic” on you and disappear into thin air. On the other hand, don’t be extra cautious with your IRA savings. If you treat your IRA too gingerly, you may be sacrificing earnings that should be coming your way.
I’ll let you in on a BIG SECRET. Investing safely does not mean giving up on robust returns. Your IRA portfolio should be constructed pretty much like your non-IRA portfolio … except it would be redundant (see “Word to the Wise,” below) to include tax-advantaged investments like munis and dividends from Real Estate Investment Trusts (REITs) in an IRA account.
Stay tuned. In future issues of ETR, I’ll be giving you some great wealth-building ideas to boost the earning power of your IRA savings to 20% a year. Maybe more.