When it comes to retirement accounts, the Roth IRA is one of my favorite tools. With tax-free growth and tax-free withdrawals in retirement, it separates itself from other accounts like 401(k)s and traditional IRAs (although those are great options, too).
How much someone will need in retirement largely depends on their lifestyle, but the $1 million mark has traditionally been a significant financial goal. Achieving this feat using only a Roth IRA isn't a walk in the park, but it's very much attainable. Here are three essential tips you should know.
Image source: Getty Images.
1. Time and compound interest are your best friends
The reality is that becoming a Roth IRA millionaire is impossible without giving yourself enough time to take full advantage of compound interest. In investing, compound interest happens when the interest you make on investments begins to make interest on itself.
To see the compounding effect in action, imagine you had invested $1,000 and earned 10% in interest each year. The following table shows the power of compound interest:
| Year | Starting Balance | Interest Earned | Ending Value at Year's End |
|---|---|---|---|
| 1 | $1,000 | $100 | $1,100 |
| 2 | $1,100 | $110 | $1,210 |
| 3 | $1,210 | $121 | $1,331 |
| 4 | $1,331 | $133 | $1,464 |
| 5 | $1,464 | $146 | $1,611 |
Chart by author. Numbers rounded to the nearest dollar.
If you removed the $100 in interest you earned each year without leaving it to compound, you would've only earned $500 in those five years. Instead, you earned $611 with no extra work because of compound interest. That example is a simplified version, but when you factor in adding money each year, and the many years of compounding, the effects are much greater.
The maximum amount you can contribute to an IRA is currently $7,000, or $8,000 if you're 50 or older. If you contributed $7,000 yearly and averaged 10% annual returns (roughly the S&P 500's long-term average), you would reach the $1 million mark in around 29 years.
2. Investing in low-cost index funds can easily save you thousands
One of the best parts of an IRA is that, unlike with a 401(k), you can invest in virtually any stock or exchange-traded fund (ETF) that you can buy in a typical brokerage account. This freedom is great because you can tailor your investments to fit your goals, risk tolerance, and time horizon.
For your Roth IRA, I recommend a low-cost ETF like the Vanguard S&P 500 ETF (VOO -1.04%). Its expense ratio is 0.03%, which works out to $2.10 per $7,000 invested. The differences in expense ratios may seem minor, but they really add up over time.
Furthering our above example, where you invest $7,000 annually, and average 10% annual returns, here's how investment totals would differ based on different expense ratios.
| Expense Ratio | Amount Paid in Fees | Account Value After 29 Years |
|---|---|---|
| 0.03% | $5,700 | $1,034,100 |
| 0.50% | $89,800 | $950,000 |
| 0.75% | $131,600 | $908,200 |
Calculations by author. Numbers rounded to the nearest hundred.
Aside from the money saved, investing in a low-cost S&P 500 ETF can remove a lot of "thinking" from investing. It's one investment and essentially acts as an investment in the broader U.S. economy, for all intents and purposes.
3. Dividends can speed up the process
Dividends are a great way to boost your total returns, especially if you use the dividend reinvestment program (DRIP) offered by most brokerage platforms. DRIPs take the dividends you're paid and automatically reinvest them back into the stock or ETF that paid it out.
As an example, imagine your investments average a 2% dividend yield. If you were to average 12% annual total returns (10% stock price appreciation plus the 2% dividend yield), you could cross the $1 million mark in around 26 years, versus the 29 years it would take without the reinvested dividends.
For perspective, here's the Vanguard S&P 500 ETF's performance over the past 20 years, with and without considering dividends.
A good plan would be to use a DRIP throughout your career to increase your shares, and then start taking cash dividend payouts in retirement. A 2% yield on $1 million worth of shares would pay you $20,000 annually, and since this would happen in a Roth IRA, it'd all be tax-free. That's a win-win.
