A Roth IRA is not an investment; it is a tax shelter that allows you to accrue money tax deferred; therefore, it is not the Roth IRA that earns money, it's the investments inside the Roth IRA that earn money. Therefore, the rate your Roth IRA earns is dependent on the investments contained therein. Following are some simple concepts to help you maximize rate of return and provide for a comfortable retirement:
The Rule of 72: This simple calculation approximates the number of years it will take to double your investment. Simply take 72, divide it by the rate your investment is earning, and you can estimate how long it will take your money to double. For example, if your investment earns 3%, your money will double every 24 years (72 divided by 3); if your investment earns 6%, your money will double every 12 years (72 divided by 6); and if your investment earns 12%, your money will double every 6 years (72 divided by 12).
What does this mean to you, the investor? A $10,000 investment at 3% will be worth $20,000 in 24 years; the same amount invested for the same amount of time at 6% will be worth $40,000; and the same amount invested for the same amount of time at 12% will give you $160,000. That's right $160,000 (10 doubled 4x) instead of $20,000. As you can see, taking advantage of the Rule of 72 can make the difference between enjoying a comfortable retirement or working until the day you die.
So how can you take advantage of the rule of 72? It begins by educating yourself. Here are some common investments for a Roth IRA and rates of return you might expect:
Banks: banks and credit unions historically have low rates of return. The Federal Reserve's recent interest rate cuts, although good for home buyers, have made savings rates even lower: savings accounts, even in the hey day of high interest rates, rarely returned more than 3%. Now you'd be lucky to get over 1 %; finding a bank certificate of deposit, even long term, at over 3.5% is nigh impossible. Once you factor in inflation, a Roth IRA at most banks or credit unions will actually lose purchasing power over time.
Money market accounts: although generally faring better than most banks, money market accounts, too, have been hurt by the slashing of interest rates. Although an excellent option for short term savings because of its liquidity and security, getting over 3.5% in today's market is highly unlikely. As with Bank IRAs, money market accounts are generally a long-term losing proposition for retirement savings.
Mutual Funds: mutual funds are generally an excellent investment for a Roth IRA. Mutual funds offer professional money management, diversification of assets, and a variety of objectives. There are literally thousands of funds available, depending on your needs. Since their inception nearly 80 years ago, stock growth mutual funds have averaged around 12%.
Wait! Before you run out and throw all that money into a stock growth mutual fund, keep in mind the relationship between risk and reward, and whether or not that type of investment is suitable for you. The following overview of fund objectives should help you manage risk while getting the highest rate of return:
1)Income funds: objective is income generation consistent with safety and stability of principal. An income fund is suitable for those who have built their nest egg and are ready to reap the rewards of their investments at retirement.
2)Conservative funds: objective is income generation with a secondary objective of maintaining purchasing power. A conservative fund attempts to keep up with inflation, while protecting the principal amount.
3)Balanced funds: objective is income generation and the potential of growth equity. Those in balanced funds are generally approaching retirement, but not so close as to completely avoid risk.
4)Growth funds: objective is long-term growth of principal. Those who are far from retirement generally invest in growth funds for the long term.
5)Aggressive growth funds: objective is long-term appreciation of principal. For those emotionally stable enough to withstand downturns in the market, high growth funds, for the long term, give the highest rates of return.
Millions of Americans have retired with millions of dollars because they took advantage of the Rule of 72 by investing in mutual funds, and took advantage of tax-deferred savings by sheltering that money in a Roth IRA.
This is by no means an exhaustive list of the different investments available for a Roth IRA, but it should provide a solid foundation in understanding the rate of return you could expect to get from your investments. As with any investment, educate yourself and seek sound advice from a variety of sources. Although there is risk involved in any investment, the greatest risk is to do nothing. So what are you waiting for? Open a Roth IRA today.