How Does a Roth IRA Work, and How Does It Grow Over Time? (2024)

Traditional individual retirement accounts (IRAs) are known for their tax advantages. But how does a Roth IRA work—specifically, how does it grow over time? Your contributions help, but it’s the power of compounding that does the heavy lifting when it comes to building wealth with a Roth IRA.

Your account has two funding sources: contributions and earnings. The former is the most obvious source of growth, but the potential for dividends and the power of compounding can be even more important.

Key Takeaways

  • A Roth individual retirement account (IRA) provides tax-free growth and tax-free withdrawals in retirement.
  • Roth IRAs grow through compounding, even during years when you can’t make a contribution.
  • There are no required minimum distributions (RMDs), so you can leave your money alone to keep growing if you don’t need it.

What Is a Roth IRA?

IRAs, both traditional and Roth, are popular savings vehicles among those who understand the importance of planning for retirement. It’s easy to open an account using an online broker or with the guidance of a financial planner.

The defining characteristic of a Roth IRA is the tax treatment of contributions. In a traditional IRA, contributions are made with pretax dollars, meaning that they reduce the amount of your taxable income when you make them; you pay income tax when you withdraw the funds later.

Conversely, contributions to Roth IRAs are made with after-tax dollars. There’s no tax break when you make them, but any contributions that you make are yours to withdraw tax-free at your discretion.

Earnings that the account accrues also can be withdrawn tax-free—but with some conditions. Generally, they cannot be withdrawn until the account has been open for five years and you reach age 59½; otherwise, you could incur taxes and penalties. If the earnings do meet both of those conditions, they are called qualified withdrawals. And qualified withdrawals are exempt from income tax.

With traditional IRAs, you get a tax break now and pay taxes later. With Roth IRAs, you pay taxes now and get a tax break later.

Many employees rely on the retirement savings accumulated through payroll deferrals made to an employer-sponsored savings plan such as a 401(k). However, IRAs allow anyone—even the self-employed—to contribute during their working years to ensure financial stability later in life.

How a Roth IRA Works

Whenever the investments in your account earn a dividend or interest, that amount is added to your account balance. How much the account earns depends on the investments that they contain. Remember, IRAs are accounts that hold the investments you choose. (They are not investments on their own.) Those investments put your money to work, allowing it to grow and compound.

Your account can grow even in years when you aren’t able to contribute. You earn interest, which gets added to your balance, and then you earn interest on the interest, and so on. The amount of growth that your account generates can increase each year because of the magic of compound interest.

Here’s an example: Assume that you contribute $3,000 to your Roth IRA each year for 20 years, for a total contribution of $60,000. Keep in mind that in 2023, you can contribute $6,500, or $7,500 if you're age 50 or older ($7,000, or $8,000 in 2024), provided that you meet the income limits.

In addition to your contributions, your account earns a very modest $5,000 in interest, giving you a total balance of $65,000. To ramp up your savings, you decide to invest in a mutual fund that yields 8% interest annually.

Even if you stop contributing to your account after 20 years, you earn 8% on the full $65,000 going forward. The next year, you earn $4,800 in simple interest ($60,000 in contributions multiplied by 8%) and $400 in compound interest ($5,000 of earnings multiplied by 8%). This increases your account balance to $70,200.

The following year, you continue to earn 8% on the sum of your contributions and previous earnings, yielding another $5,616 in total interest. Your balance is now $75,816. You gained nearly $11,000 in just two years without making any additional contributions. In the third year, you earn $6,065, increasing your balance to $81,881.

If you fast forward another five years, your account earns another $38,429 in interest, and your total balance is $120,310. Without making any contributions to it, your Roth IRA has nearly doubled in the past eight years through the power of compound interest.

No Required Minimum Distributions (RMDs) for Roth IRAs

With traditional IRAs, you have to start taking required minimum distributions (RMDs) when you reach age 73, even if you don’t need the money. That’s not the case with a Roth IRA. You can leave your savings in your account for as long as you live, and you can keep contributing to it indefinitely, as long as you have qualifying earned income and yourmodified adjusted gross income (MAGI) doesn’t exceed the annual limitfor making contributions.

These features make Roth IRAs excellent vehicles for transferring wealth. When yourbeneficiary inherits your Roth IRA, generally, they will have to take distributions that could be stretched out over 10 years. This can provide years of tax-free growth and income for your loved ones.

Advisor Insight

Scott Snider, CPF®, CRPC®
Paragon Wealth Strategies, Jacksonville, Fla.

Think of the Roth IRA as a wrapper around your money that provides tax-deferred growth, so that when you retire, you can withdraw all of the contributions and earnings tax-free.

Roth IRAs are especially appealing to younger investors because the growth can be as high as four to eight times what they originally invested by the time they retire.

The actual growth rate will largely depend on how you invest the underlying capital. You can select from any number of investment vehicles, such as cash, bonds, stocks, ETFs (exchange-traded funds), mutual funds, real estate, or even a small business.

Historically, with a properly diversified portfolio, an investor can expect anywhere between 7% to 10% average annual returns. Time horizon, risk tolerance, and the overall mix are all important factors to consider when trying to project growth.

Max Out Your 401(k) Match First

Of course, a Roth IRA shouldn’t be the only way that you work on building a nest egg. If you have access to a 401(k) or similar plan at work, that’s another great place to save for retirement. Here’s why:

  • If you get an employer match, you get an automatic 100% return on part of the money that you invest in your 401(k).
  • 401(k)s are tax deferred, so your money grows faster.
  • You get a tax deduction for the year when you contribute, which lowers your taxes (and gives you more to invest).
  • There are high contribution limits: In 2023, you can contribute $22,500, or $30,000 for those over age 50 ($23,000 and ($30,500 for 2024).

A good strategy is to fund your 401(k) first to ensure that you get the full match, then work on maxing out your Roth. If you have any money left, you can focus on rounding out your 401(k).

What Is Compound Interest?

Compound interest means that when interest is earned on your money, it is reinvested into the account. Doing so means that it earns even more interest. This cycle allows modest contributions to grow exponentially over time.

Will a Roth IRA Provide Enough Money for Retirement?

While a Roth individual retirement account (IRA) is a great tax-advantaged tool, most people should invest in other vehicles as well, such as a 401(k), Simplified Employee Pension (SEP) IRA, or other employer-sponsored plans. You may want to consider your standard of living when considering how much to save. Typically, investors are told to plan on living on 80% of their current monthly budget.

Do I Have To Keep Contributing to My Roth IRA?

Technically, no, but the rate of growth depends on when you start investing. If you start early, then you have the benefits of time and compound interest on your side. Even a modest contribution will grow over time if you start early but stop contributing after a while. Starting later will necessitate more up-front investment, and you will need to continue contributing for longer in order to reach the same goals.

The Bottom Line

Roth IRAs take advantage of the power of compounding. Even relatively small annual contributions can add up significantly over time. Of course, the sooner you get started, the more you can take advantage of compounding—and the better your chance of having a well-funded retirement.

How Does a Roth IRA Work, and How Does It Grow Over Time? (2024)


How Does a Roth IRA Work, and How Does It Grow Over Time? ›

How a Roth IRA can earn interest. A Roth IRA can increase its value over time by compounding growth. Whenever investments earn interest or dividends, that amount gets added to the account balance. Account owners can earn interest on the additional interest and dividends, a process that can continue over and over.

How does a Roth IRA grow over time? ›

Your account can grow even in years when you aren't able to contribute. You earn interest, which gets added to your balance, and then you earn interest on the interest, and so on. The amount of growth that your account generates can increase each year because of the magic of compound interest.

How much will a Roth IRA grow in 10 years? ›

Let's say you open a Roth IRA and contribute the maximum amount each year. If the base contribution limit remains at $7,000 per year, you'd amass over $100,000 (assuming a 8.77% annual growth rate) after 10 years. After 30 years, you would accumulate over $900,000.

How much will a Roth IRA earn in 20 years? ›

If you contribute 5,000 dollars per year to a Roth IRA and earn an average annual return of 10 percent, your account balance will be worth a figure in the region of 250,000 dollars after 20 years.

How long does it take for a Roth to mature? ›

The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This five-year rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.

Is a Roth IRA better than a 401k? ›

A Roth IRA might be the better choice if you:

Want access to a wider range of investment options. Want to be able to withdraw contributions tax- and penalty-free before you turn 59½ without making a plan loan. Have no inclination toward taking RMDs when you turn 70½ or 72.

How long does it take to become a millionaire with a Roth IRA? ›

Long-time personal finance columnist Scott Burns writes that by working for four summers starting at age 16, putting the money in a Roth IRA, investing it wisely, and waiting until age 67, it's simple to become a millionaire. 1 That's the 51-year plan. But what if you're not that patient—or that young?

How much should a 25 year old put in a Roth IRA? ›

If you're 25, you should aim to max out your IRA every year. For 2024, a 25-year-old can contribute up to $7,000 to an IRA. It might seem unnecessary to save for retirement at such a young age, but giving your money time to grow is one of the best things you can do for your future self.

Do you pay taxes on Roth IRA? ›

Roth IRAs allow you to pay taxes on money going into your account and then all future withdrawals are tax-free. Roth IRA contributions aren't taxed because the contributions you make to them are usually made with after-tax money, and you can't deduct them.

Can I open a Roth IRA if I make 200k a year? ›

Bottom Line. As an individual making $200,000 per year, you cannot contribute to a Roth IRA if you're single, but can if you're married and file jointly.

Is 35 too late for a Roth IRA? ›

Even when you're close to retirement or already in retirement, opening this special retirement savings vehicle can still make sense under some circ*mstances. There is no age limit to open a Roth IRA, but there are income and contribution limits that investors should be aware of before funding one.

Does a Roth IRA grow without investing? ›

The money in the account can continue to grow even without the owner making regular contributions. Unlike traditional savings accounts that have their own interest rates that periodically adjust, Roth IRA interest and the returns account owners can earn depend on the portfolio of investments.

What is the 10 year Roth rule? ›

Roth IRA owners have no required minimum distributions during their lifetime, but Roth beneficiaries are still subject to the 10-year rule. But a little advantage if you inherit a Roth: If you're subject to the 10-year rule, you never have to take years one through nine RMDs, no matter how old you are.

Does Roth IRA have a 5 year rule? ›

The Roth IRA five-year rule says you can withdraw your investment earnings tax-free and penalty-free as long as you've held the account for at least five years. It's important to note this rule applies specifically to investment earnings.

Is there a 5 year rule for Roth IRA? ›

5-Year Rule for Roth IRA Withdrawals

To be tax-free, you must withdraw the earnings: On or after the date when you turn age 59½ At least five tax years after the first contribution to any Roth IRA that you own.

Is a Roth IRA a good long term investment? ›

A Roth IRA is one of the best possible ways to invest for retirement, and in fact, many experts think it's the single best retirement account to have.

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