How Compound Interest Makes Roth IRAs Worth It

A Roth individual retirement account (IRA) allows you to save for retirement with money that has already been taxed. Qualified withdrawals from a Roth IRA are then tax free, an attractive option for people who expect to be in a higher tax bracket in retirement. 

Compound interest can play a big part in determining how much your retirement savings can add up to over time. The sooner you get started saving with a Roth IRA, the more opportunity your money has to grow through the power of compounding. 

The Rules for Roth IRAs

A Roth IRA is a retirement account funded with after-tax dollars. It allows for qualified tax-free distributions. The Internal Revenue Service (IRS) establishes specific rules for Roth IRAs, including those for contributions and withdrawals.

Here are some of the key tax rules for Roth IRAs:

• Contributions are not tax deductible.
• Qualified distributions, including distributions beginning at age 59½, are tax free.
• Original contributions can be withdrawn at any time without a tax penalty.
• Required minimum distributions (RMDs) do not apply.

Roth IRAs have annual contribution limits. The annual maximum is $6,000 in 2022, with an additional $1,000 catch-up contribution allowed if you're 50 or older. This increases to $6,500 in 2023.

The maximum amount you can contribute to a Roth IRA each year is based on your income and filing status. For example, you cannot contribute to a Roth IRA if your modified AGI (MAGI) is greater than or equal to $10,000 and you're married and file a separate tax return. Much more generous limits apply to single taxpayers, heads of household, qualifying widow(er)s, and married taxpayers who file joint returns.

What Is Compounding Interest?

Compounding interest is interest earned on your interest. You may be familiar with compounding interest based on your experiences with a bank account or CD. When you contribute to any type of account, those contributions are referred to as your principal. 

As your investments earn interest, that interest is added to the principal. You then earn interest on both the principal and the interest you've already earned. Compound interest can be more powerful than simple interest for growing your money over time. 

How Does a Roth IRA Grow?

A Roth IRA is designed to hold investments that will ideally increase in value over time. You're not automatically investing in anything when you open a Roth IRA. You're simply creating a vessel to hold the money you plan to invest for retirement. You must then take the additional step of choosing Roth IRA investments. These can include:

• Individual stocks
• Exchange-traded funds
• Mutual funds
• Target-date funds
• Money market funds
• Bonds or bond funds
• Certificates of deposit (CDs)
• Cash and cash equivalents

Your investments can earn interest or dividends over time. A dividend is a percentage of profits that a company pays out to its shareholders. Roth IRA compound interest works through adding reinvested interest or reinvested dividends to your principal to earn interest on your account balance continuously.  Some investments, such as mutual funds, stocks, and exchange-traded funds, could appreciate in price annually, which also compounds over time. 

Your investments can impact your compounding growth. Your returns can vary more and may not be as dependable if you’re putting your money into higher-risk investments. Some years you may even lose money.  Dividends and interest on bonds can vary, too. 

The higher an investment’s average annual return (such as 6% vs. 4%), the less you have to deposit because compound interest works for you. Here’s a comparison of one deposit of $1,000 and different rates of compounding interest, even if you didn’t continue to add to your Roth IRA account:

Roth Advantages for Compounding Interest

A Roth IRA offers numerous tax advantages to those who are eligible to make contributions. Even though you can't claim a deduction for contributions on your tax return, you can withdraw your contributions and earnings tax free when you retire. This can help you maximize the compounding interest earned because you don't have to worry about taxes nibbling away at your account growth. 

Roth IRAs are also free from required minimum distributions (RMDs). This IRS rule requires that you begin to take money from a traditional IRA at age 72, but it doesn't apply to Roths. You can leave your money in your account for continued growth until you need it. And you can keep making contributions to your Roth account until you retire (and therefore no longer have earned income, one of the key requirements) if you're still working.

A Roth Growth Example

How much can Roth IRA compound interest add to your account balance over time? Let's say that you open a Roth IRA and deposit $6,000 initially, at age 25. Then you deposit another $500 per month, and earn the same 7% annual rate of return for the next 40 years. Every year, you’re contributing $6,000 in total, the Roth contribution limit until age 50.

You'd be a millionaire at age 65. You would have contributed just $246,000 in total, but thanks to compounding, you would have $1,287,657.42 saved for retirement. 

All the profits earned would be tax free if you don't touch the money until you retire or reach age 59½. That could significantly reduce your tax bill if you anticipate being in a higher tax bracket in retirement. Any Roth IRA funds not used during your lifetime can be passed on to a beneficiary. 

Setting Your Retirement Investing Priorities

It's important to understand what tools you have for saving when you're creating a retirement plan. You should know how they can benefit you from a financial perspective. For example, maxing out those contributions first can make sense if you have a 401(k) plan at work. This will reduce your taxable income for the year. It's a good idea to contribute at least enough to get the full employer matching contribution if one is offered. 

Opening a Roth IRA could be the next step if you have more money available to save for retirement. Even if you're not able to make the full contribution each year, you can still benefit from tax-free earnings and the power of Roth IRA compound interest. 

Frequently Asked Questions (FAQs)

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