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Why Roth IRAs are great for young earners: the power of compounding (part 2)

Power of compounding investments when start saving young
March 21, 2018

By Pam Leibfried

Part one of this series covered why a Roth IRA can be a great retirement savings vehicle for many young professionals. We talked about the tax benefits and flexibility of Roth IRAs, but only briefly touched on the huge benefits you could potentially reap from starting to save for retirement at a young age.

In today’s follow-up, we’ll take a deeper dive into the power of compound growth of your investment over decades. We’ll do this by modeling some hypothetical investment amounts over time. I want to remind you all again, before we start talking numbers, that there are never any guarantees when you’re investing.1 The numbers below show how a retirement savings investment could potentially grow over time, but your investment may not grow at that rate or may not grow at all.

To illustrate the potential long-term compound growth for two hypothetical contribution scenarios, I ran calculations using the current Roth IRA maximum contribution amount of $5,5002*compounded at four different historical rates of return.

I calculated for five percent returns (the fairly conservative estimate I often use when modeling my own retirement scenarios), seven percent, 10 percent and 12 percent (Dave Ramsey’s rosier estimate of returns). And if you’re wondering how there can be such a variance in stating a historical number, it’s because different calculations use shorter or longer timespans and account for inflation using different formulas.

Contribution scenario 1: Potential growth of annual $5,500 contribution 

A 22-year-old making a $5,500 annual contribution for 43 years (through age 65).

                                                                                                                                                                                                                                                                                                      

Annual
            contribution           
Average annual            
            rate of return     
Tax-free balance 
            at age 65    
$5,500 5 percent      $814,000
$5,500 7 percent $1,460,000
$5,500 10 percent $3,800,000
$5,500 12 percent $7,470,000

Estimates created using the Nerdwallet Roth IRA calculator.
 

Contribution scenario 2: Potential growth of single $5,500 contribution

A 22 year-old making a single $5,500 contribution and letting it compound for 43 years.
(Obviously not a recommended savings strategy; however, it's a powerful illustration of long-term compound growth)

                                                                                                                                                                                                                                                                                                      

Contribution
            at age 22           
Average annual            
            rate of return     
Tax-free balance 
            at age 65    
$5,500     5 percent        $44,823.17
$5,500   7 percent $100,893.95
$5,500 10 percent $331,320.38
$5,500 12 percent $719,014.53

Estimates created using the US Securities and Exchange Commission’s compound interest calculator.


* Keep in mind that the IRS reevaluates and adjusts the maximum contribution limit annually based on inflation, so if you started maxing out at $5,500 now and increased your contributions as the IRS raised its contribution limits, you’d end up with even more than this $5,500 contribution shows.
1. The information in this article is for general information only and is not intended to provide specific advice or recommendations for any individual, as each individual's financial situation and investment risk tolerance is different. To determine which investment(s) may be appropriate for you, consult with your financial advisor to discuss your personal situation prior to investing. Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of or guaranteed by the financial institution.
2. The IRS limit for contributions to Traditional and Roth IRAs in 2018 is $5,500, or your total earned compensation, whichever is less. In other words, someone who earns $3,500 in 2018 could only contribute $3,500 to an IRA. Eligibility to contribute to IRAs is subject to IRS income phaseouts. The 2018 Roth IRA Modified Adjusted Gross Income (MAGI) Limit is $199,000 for married couples filing jointly and $135,000 for singles. Couples who are married filing jointly can max out contributions to IRAs for both spouses as long as the working spouse’s income is more than the total amount contributed. For example, under current contribution limits, you can contribute up to $5,500 to each spouse’s IRA (subject to IRS income phaseouts) if the working spouse makes $11,000 or more that tax year. Each person must open his/her own IRA. Consult with your tax advisor for additional tax information.

Pam Leibfried is a marketing content specialist whose love of words led to a writing and editing career. After a brief stint teaching English, she transitioned to corporate communications and spent 20 years at The Nielsen Company before joining Alliant’s content development team. Early in her work life, Pam’s friend Matt explained the benefits of a 401(k) and her dad encouraged her to start a Roth IRA. Their good counsel prompted her to prioritize retirement savings, which just might enable her to retire early so she can read more and live out the slogan on her fave T-shirt:  “I have a retirement plan: I plan on quilting.”