Get the Most Out of Your Roth IRA

Roth IRA, 401(k), traditional IRA, which one do you choose? My recommendation is a Roth IRA and there are many reasons for this. It is optimal to break down an IRA into four sections. How a Roth IRA earns interest, how to choose your investments, what you can control, and what you can't control. Let's dive straight into it.

How a Roth IRA earns interest

Let's use an example. Suppose you invest $1,000 into your Roth IRA with an investment in a CD (certificate of deposit) earning 3% per year. You will earn $30 in interest that first year. If you reinvest that $30 and your initial $1,000, you will make $30.90 the second year. Every year you will earn more and more interest that compounds on top of each other. It doesn't sound like much but compounding over 20 years is very powerful.

You will want to choose funds that deliver dividends so your money will compound. Additionally, stocks with high growth increase your capital over time. Interest and growth over a span of 20 years will create a sizeable amount of capital. You can do this with any individual brokerage account, so why choose a Roth IRA? People who have a Roth IRA pay taxes each year they make a contribution but do not pay any taxes on growth or withdrawals when you take the money out for retirement. This is massively beneficial.

How to choose your investments

What is your time horizon? If you plan on investing in your 20's, it is advisable to take more aggressive risks because the upside you can make long-term is tremendous. As a young investor, invest your money through a brokerage, not a bank. The banking system offers poor investment options. If you are just starting, it's always a good idea to reserve a portion of your funds by investing in a broad market index fund.

Roth IRAs have a much more extensive selection of investment options than a 401(k) offers. The only three investments I have found off-limits for a Roth IRA are collectibles, life insurance, and shares of an S corporation. Unlike a 401(k), a Roth IRA offers portfolio diversity of individual stocks, indexes, ETFs, bonds, or mutual funds that satisfy the needs of most investors.

An incredible investment to make if you are in your 20's is to buy a broad market index fund that tracks the S&P 500. Indeed you will see stunted returns in a few years but over 20 years, woah, talk about smart long-term gains. After adjusting for inflation, the S&P 500 has returned 7% per year historically speaking.

Growing your funds with a Roth IRA is the most important thing here. The goal is to have enough money for retirement, so let's discuss a few important factors you should consider when investing in a Roth IRA.

What you can control

You control how much you invest each year. To maximize your returns, it is wise to maximize the amount you contribute each year. The contribution limit is $6,000 per year for someone under 50 years of age.

You control your withdrawals. Roth IRAs allow you to withdraw your contributions without penalty. If times are tough and you need to access your contributions, you are able to withdraw those with no questions asked. But, doing so will stunt your long-term returns. To maximize the benefits of a Roth IRA, it is wise to continue investing your funds year after year and let compound interest work its magic. Although you might not make a whopping amount of interest in the first few years, 20 years from now, the compound interest you have accumulated will far exceed your initial investment.

What you can't control

You can't control your exact returns. I could give you a long spiel about how your exact returns relate to macro-economics and the financial performance of individual companies, but you can read other articles for those details. Sticking to the basics, the question to ask is, how can you be sure that your investment will grow in leaps and bounds? Unfortunately, you don't. It is impossible to predict the market returns you will make in the short-term, and equally impossible to predict your long-term gains.

Final Thoughts on the Matter

The best and most proven way to alleviate the impact of factors outside of your control is to let your money ride out the market's ups and downs for as long as possible. Long-term investing is the easiest and most practical way to build wealth. It is simple enough for the average man to figure out because you don't need to make day trades or become officially absorbed into the stock market's monthly news. The key to building wealth long-term is in a man's mindset and who they choose to be batboy for. Learn from your predecessors, be willing to adopt old and new ways of thinking, and follow a blueprint to long term wealth.

If you don't have your own blueprint and need to create one, I recommend books like Intelligent Investor, Random Walk Down Wall Street, and One Up On Wall Street. These books are advanced level books. If you want to start with a beginner/intermediate investing book, use 7 Investments In Your 20's That Will Change Your Life. The blueprint you'll find in 7 Investments In Your 20's That Will Change Your Life will open all the doors you need to go through when becoming a confident and successful investor.

Good investing,

Dan Sarver