A Roth individual retirement account (IRA) allows you to save for retirement with money that has already been taxed. Then, qualified withdrawals from a Roth IRA are 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 adds 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.
- A Roth IRA is a tax-advantaged retirement savings account designed for people who have earned income and are within certain income thresholds.
- Roth IRAs are funded with after-tax dollars, and qualified distributions are tax-free.
- Compounding makes it possible to grow retirement savings faster than earning simple interest.
- The Roth IRA compound interest rate you could earn can depend on how much you contribute, how long you're saving, and how well your investments perform.
Compound Interest and Your Roth IRA
A Roth IRA is a retirement account funded with after-tax dollars and allows for qualified tax-free distributions. The Internal Revenue Service (IRS) establishes specific rules for Roth IRAs, including rules on 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 59 ½, 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- Original contributions can be withdrawn at any time without a tax penalty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. For 2022, the annual maximum is $6,000, with an additional $1,000 catch-up contribution allowed if you're 50 or older. The maximum amount you can contribute to a Roth IRA is based on your income and filing status. For example, if you're married and file separate returns, you cannot contribute to a Roth IRA if your modified AGI is greater than or equal to $10,000.
In general, 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 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 made. 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 ideally will increase in value over time. When you open a Roth IRA, you're not automatically investing in anything. You're simply creating a vessel to hold the money you plan to invest for retirement.
You still need to take the additional step of choosing Roth IRA investments, including:
- 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 compound over time.
So, your investments can impact your compounding growth. If you’re putting your money into higher-risk investments, your returns can vary more and not be as dependable. Some years you may even lose money. Dividends and interest on bonds can vary, too.
The higher an investment’s average annual return (for example, 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 the Roth IRA account:
Roth Advantages for Compounding Interest
A Roth IRA offers numerous tax advantages to those eligible to make contributions. Even though you don't get a deduction for contributions on your taxes yearly, you can withdraw your contributions and earnings tax-free when you retire. This can help you maximize the compounding interest earned as you don't have to worry about taxes nibbling away at your account growth.
Roth IRAs are also free from required minimum distributions. This IRS rule requires you to start taking money from a traditional IRA at age 72, but it doesn't apply to Roth IRAs. So you can leave your money in your account for continued growth until you need it. And if you're still working, you can keep making contributions to your Roth account until you retire (and therefore no longer have earned income, one of the key requirements).
Withdrawing Roth IRA funds early could result in tax penalties, detracting from the benefits of compounding interest. Ensure you understand the rules before withdrawing any profits from your Roth IRA.
A Roth Growth Example
How much can Roth IRA compound interest add to your account balance over time? 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. At age 65, you'd be a millionaire. You would have contributed just $246,000 in total, but thanks to compounding, you would $1,287,657.42 saved for retirement.
But all of the profits earned would be tax-free if you're not touching it until you retire (or reach age 59 ½). 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 could be passed on to a beneficiary.
Setting Your Retirement Investing Priorities
When creating a retirement plan, it's important to understand what tools you have for saving and how they can benefit you from a financial perspective. For example, if you have a 401(k) plan at work, maxing out those contributions first can make sense, reducing your taxable income for the year. At a minimum, it's a good idea to contribute at least enough to get the full employer matching contribution if one is offered.
If you have more money available to save for retirement, opening a Roth IRA could be the next step. 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)
How often does a Roth IRA compound interest?
Generally, when discussing how often Roth IRA interest compounds, you're talking about the annual rate of return. This represents the average returns (including price growth, dividends, and interest) earned by the different investments in your account for the year.
How fast does a Roth IRA grow?
The rate at which a Roth IRA grows can depend on how often you're making contributions and how often your investments earn interest and dividends. The more consistent you make contributions, the faster your balance may grow over time.
How does simple interest differ from compound interest?
Simple interest is interest earned on the principal only. Compound interest is interest earned on both the principal and the already accrued interest.
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IRS. "Roth IRAs."
IRS. "IRA FAQs."