Invest $5,000 a year at 18 in a Roth IRA, with a 10% return; you will have accumulated $7,757,361 at the age of 70. If you had waited to the age of 25, you would have only $3,953,977.
Next, assume you start at 18 and contribute $5,000 a year and earn 11%. At the age of 70, you will have $11,423,026.
Examples of compound interest are not only motivating they are educational. As you can see, 7 years make a huge difference. Plus, a 1% change in return also has a dramatic impact.
The second part of the Roth IRA series will cover the important topics of when to start and what to invest in to maximize the growth of your Roth IRA.
When To Start Investing In Your IRA
There are many theories to when someone should start contributing to a Roth IRA. While everyone is different, before contributing to a Roth IRA, you should have accomplished two things.
- Paid off high interest debt
- Take full advantage of any matching in your 401K
You will never build wealth by paying a large part of your monthly income to interest. If you still have high interest debt, like credit card debt, you must pay it off before investing.
Certain low interest debt like mortgage payments and student loans can wait. Take advantage of compound interest while you can.
Besides having all of your high interest debt paid off, before investing in a Roth IRA, you should have contributed enough to your 401K to receive the full matching contribution. For example, if your employer matches the first 50% of your contributions up to 6%, you must contribute 6% before doing any other investing. Not taking advantage of your employer’s matching contribution is like throwing away money.
What To Invest In
Whatever you do, don’t do what I did.
Once I found out about all the advantages of a Roth IRA, I started looking for that perfect investment. So I soaked up everything I could on asset allocation and diversification.
I decided to start a few different strategies that I had read about. My portfolio consisted off a few individual stocks, an expensive mutual fund, and a few ETF’s.
Since I was new to investing, I looked at my portfolio at the end of each day. If I had more money in my account, I was pretty excited. The concept of earning money doing no work at all was new to a 20 year old college kid.
The days my balance would go down soon outnumbered the exciting positive days. However, I never stopped reading and learning about investing.
I eventually found the many holes my “investment philosophy” had. My downfall was that I was worrying about all the wrong things. Instead of worrying about my return 40 years from now, which is what really matters, I was more worried with my daily returns.
It didn’t really matter what my investments did from a day-to-day, month-to-month or even year-to-year basis. I had no control over the outcomes. As an individual investor all I really had control over was expenses, asset allocation, and diversification.
After about six months, a few hundred dollars paid to brokerages, and hours and hours upon research, I decided to invest in a Target Retirement Fund. The investments inside of the fund were already customized for someone with my expected retirement. In addition, the fund’s expenses were the lowest I could find.
Another great benefit was that I didn’t have to worry about it. A Target Retirement Fund’s allocation adjusts automatically according to my age. To learn more,, here is a great introduction to Target Retirement Funds.
I would recommend a Target Retirement Fund to anyone. They are a simple solution to a very complex problem.
Where To Invest In A Roth IRA
Not all Target Retirement Funds are created equal. There are plenty of mutual fund companies who want the privilege of managing your money. It’s not easy to sort through all the marketing fluff and get down to the facts that really matter.
Hopefully, I can save you a little time. I would start your search by looking into T. Rowe Price or Vanguard.
Which company you choose depends on your circumstances. Vanguard has low expense ratios, but a higher minimum investment. Although, if you invest in Vanguard’s Star Mutual Fund, the minimum initial investment is $1,000 compared to $3,000 for Target Retirement Funds. The Star Mutual Fund’s asset allocation is a bit conservative for most Gen Y investors. However, once you have $3,000 invested you can always switch to a Target Retirement Fund.
T. Rowe Price makes it very easy to start investing. If you commit to contributing just $50 a month into your account, you can invest in their no load mutual funds. My favorite part about T. Rowe Price, is that they take away the excuse of not having enough money to invest in an IRA.
Vanguard and T. Rowe Price are not the only two options. If for any reason you wish to look for a different solution, here’s what to keep in mind.
- Low Expense Ratios – A high expense ratio might seem of little significance now, but as your account grows and grows over time the more important the expense ratio. If you had $1,000,000 in your account and switched to an expense ratio that was .5% lower, that’s a savings of $5,000 per year.
- Minimums – The smaller your initial investment, the more limited your options might be. Companies like T. Rowe Price might waive the minimum if you contribute consistently.
- Account Fees – Most mutual fund companies have account fees. These are small fees each year for tax forms, statements…etc. Make sure it’s reasonable; under $50 for the entire year. Even better, check to see if fees are waived if you choose to receive everything electronically.
- Customer Service – Your mutual fund company should treat you better than your cable company. Place a call towards prospective mutual fund companies. You want to make sure you get a person on the phone quick. Plus, ask a few questions to the customer service rep to see their knowledge.
- Transaction Fees – Some people might be tempted to go with a brokerage instead of a mutual fund company. If you’re paying $10 a trade to your brokerage company on a $100 trade, that’s equivalent to a 10% load. Be careful of transaction fees.
You can get all this information in the prospectus. A prospectus should be available through the companies website. Read the whole thing. Some of it might be a little boring, but you will learn a lot.
Tips For Investing In Your IRA
Investing isn’t very complex. I made the mistake of over thinking a simple problem. After all the work I did, I ended up investing in the Vanguard Target Retirement 2050 Fund.
Recently, I helped my wife set up her Roth IRA. It amazed her at how easy it really was. Her comment was, “that was as simple as setting up a checking account.”
For about three years, I have managed to contribute the maximum amount. I did this by paying myself first. The day after my paycheck hits, I had Vanguard automatically deduct the money from my bank account.
After setting up your Roth IRA, the first step you need to take is to automate the contributions. Even if it’s as little as $50 a month, paying yourself first is a great way to build wealth.
Part 3 of the series on IRAs will be a very detailed post covering limits and laws that you need to know.
If you have any questions that you need answered, please leave a comment below.