A million bucks may seem like a good amount to have for retirement, but how does one work towards achieving this in their IRA? This article talks about how to become a millionaire with a Roth IRA using key investing principles.
In this article:
How to Become a Millionaire Through a Roth IRA
Why a Roth IRA?
One of the reasons for considering a Roth IRA as a vehicle for becoming a millionaire retiree is taxes. Compared to a Traditional IRA, qualified withdrawals from a Roth IRA are tax-free.
This is because income used to fund contributions to a Roth IRA is already taxed by the IRS. On the other hand, the IRS allows taxpayers to use their Traditional IRA contributions as tax deductions on their returns.
A Roth IRA allows investments under it to grow at a tax-free rate until retirement. This is because taxpayers have already paid taxes on the income that funded such investments.
With Traditional IRAs, taxpayers will pay taxes on future withdrawals. This includes taxes on the initial contributions and the income they earned throughout the years.
By paying taxes on the income that fund contributions now, taxpayers can save a lot on future taxes after their Roth IRA investments have grown so much over the years.
The Other Roth: The Roth 401(k)
An employer-sponsored Roth 401(k) is also worth considering when it comes to fulfilling one’s millionaire retirement dreams. There are several reasons for this:
- As the name implies, contributions to this type of 401(k) come from after-tax income. This means taxpayers won’t pay taxes on withdrawals from this kind of 401(k) upon retirement.
- Another reason for considering an employer-sponsored Roth 401(k) is higher contribution limits. Taxpayers can only contribute a maximum of $6,000 to $7,000 annually to IRA accounts, which they can distribute between Traditional and Roth IRAs.
- On the other hand, taxpayers can contribute a substantially larger amount to a Roth 401(k) every year. As of 2019, taxpayers can contribute a maximum of $19,000 to $25,000 annually to a Roth 401(k).
- There is also the possibility of employer matching contributions (pre-tax and accounted for separately upon retirement).
How to Become a Millionaire with a Roth IRA
1. Start Early
The best time to start investing for retirement is as soon as possible. Why?
Regardless of the amount required for the future, saving over a longer period of time is easier compared to a shorter one.
- A 25-year-old who starts saving for retirement now has a maximum of 35 years to do so. Dividing one million dollars over 35 years requires a minimum annual savings of $28,571.
- A 40-year old who starts saving for retirement today only has a maximum of 20 years to do so. With the same target of one million dollars upon retirement, this person needs to save at least $50,000 annually.
The impact of starting early is magnified by a financial concept known as compound interest. And speaking of which…
2. The Most Powerful Retirement Tool: Compounding
Compounding, a.k.a. compound interest, is such a big deal that even Albert Einstein once alluded to it as mankind’s greatest invention. Why?
Compound interest is also called “interest on interest”, which means income earned from investments is reinvested again to earn more. Consider an $1,000 investment at 10% annually.
- During the first year, that investment will earn $100, growing the initial investment to $1,100.
- Investing the $100 income together with the original principal of $1,000 again at 10% for another year will yield $110.
By reinvesting the interest or income from investments together with the initial investment amount, investors can increase their investments without putting in more money. And as the amount in their investments grows, investment income continues to grow over time, too.
Using the $1,000 initial investment example, reinvesting income at an average annual rate of 10% for 20 years can make it grow to $6,727.50. That’s 673% growth in 20 years without putting in more money.
The best way to visualize how compound interest works is a snowball rolling down a snowy mountain. Just like in cartoon shows, compound interest can make a small “snowball” of an investment grow substantially over time.
To maximize the power of compounding, one must avoid or minimize withdrawing from investments. The amount of regular withdrawals can significantly dampen the compounded growth of one’s investments.
3. Increase Savings
There are three important factors that determine a person’s ability to become a millionaire retiree. These are the investment time horizon, the rate of return, and the amount of investment.
The greater the amount of the investment, the greater the investment income can be, assuming the same rates of return and time frames. The more money a person sets aside for a retirement investment account such as a Roth IRA, the easier that person can achieve the millionaire retiree dream.
Based on a study on workplace 401(k) millionaires by Fidelity investments, the most successful retirement investors tend to save up to 15% of their income. It also revealed that most people preparing for their retirement tend to set aside an average of just 3%.
Remember the other Roth, the Roth 401(k)? Investors can use it to ramp up their retirement savings and investments with free money from their employers.
Even if retirees will have to pay taxes on withdrawals of the employers’ share of the Roth 401(k) upon retirement, they can still get a much higher amount.
4. Salary as a Roth IRA Strategy Guide
According to Fidelity Investments, a good savings goal for people preparing for retirement is eight times the annual salary by age 60. For some, their savings goal may be higher, such as up to 12 times one’s annual income.
The bottom line is, one must have saved enough money so that compounding can work its magic and create that million-dollar pot.
5. Consider Fees
One factor most retirement planning taxpayers take for granted are fees. Investing money in a Roth IRA isn’t free because people and infrastructure are needed to manage them.
Some fees are higher for certain types of investments and for some, they’re lower. Actively managed funds typically have higher fees compared to index-tracking funds.
Investors should always keep in mind that because fees are in percentage form, they increase when a Roth IRA’s balance increases. That’s why factoring fees in one’s Roth IRA strategy is very important.
Investing in a Roth IRA doesn’t guarantee that one can retire a millionaire. But if investors play their cards right and take advantage of a Roth IRA’s tax benefits and supplement it with a Roth 401(k), they can make their millionaire retiree dreams come true.
Do you think a million dollars will be enough to live on after retirement? Let us know why or why not in the comments section below.