It’s been called the eighth wonder of the world and the most powerful force in the universe. When harnessed properly, it can transform average earners into millionaires.
Compound interest is like a river of wealth that’s constantly flowing, available to anyone who chooses to access it. It multiplies your money over time, allowing you to earn more and more interest as your nest egg grows.
There are just three things you need to tap into this flow of wealth: money, time and a compound interest-earning account. For the latter, many people choose an IRA, an account made for holding long-term savings and retirement investments. Based on current IRS contribution limits, each individual can contribute up to $5,500 a year to an IRA (or $6,500 if you're 50 or older), or the individual’s taxable compensation for the year if it was less than that amount, earning a compound interest rate that varies depending on the type of account you choose.
There are different types of IRAs, which makes them an incredibly versatile savings and investment tool—yet just one in three Americans actually have one. Here’s a look at some of the options available.
Roth vs. Traditional IRA
IRAs come in two primary flavors: traditional or Roth. Both have their benefits and uses, depending on your financial needs.
With a Traditional IRA, you don’t have to pay taxes on your contributions until you start making withdrawals. Your contributions may be tax deductible, which means you may be able to use them to lower your tax bill while also saving money; consult your local tax professional to find out whether this strategy might work for you. The downside to a Traditional IRA, however, is you’ll have to pay the taxes during your retirement.
When you open a Roth IRA, your contributions aren’t tax-deductible, which means you pay income taxes on the funds now so you won’t have to when you start making withdrawals. This can be a boon when you’re living on a fixed income. But the biggest benefit of a Roth IRA is that you can withdraw your Roth contributions tax- and penalty-free, leaving your retirement savings accessible in case you need it.
Saving vs. investing
IRAs can also vary based on the types of account you choose—and that depends on your goals. Are you looking for a safe place to grow your money slowly over time? Or a riskier investment with the potential to net you a higher yield?
An investment IRA invests in mutual funds, stocks, bonds and other investments that fluctuate with the market. You can buy and sell them within the IRA, and all transactions are tax-free. A high-performing portfolio can provide you with more retirement income, while a low-performing investment can cause your IRA to lose value.
A savings IRA, on the other hand, focuses on fixed investments with a rate of return that’s guaranteed by the financial institution. These typically earn lower yields than an investment IRA, but they keep your savings more secure. Since the CDs are insured by the FDIC, your account won’t be vulnerable to market fluctuations.
With so many options available, it’s important to be strategic when choosing the best type of IRA for you. Decide on the outcome you want, and align every decision you make with that central purpose. And don’t forget to consider the impact of time on your compound interest. Do you have plenty of years before retirement to play it safe? Or are you looking to make up for lost time?
With the right IRA and enough time, you can tap into the incredible power of compound interest.
We’d be happy to discuss how to put an IRA to work for you. Contact us to learn more.