Turning $5,000 into $110,000 (Tax Free) – All it takes is time

Yes, you can easily turn $5,000 into $110,000.  No, it’s not a scam and no, you can’t do it overnight.  Today I will be going through the ins and outs of a Roth IRA.  A Roth IRA is a retirement account that has significant tax advantages compared to other retirement accounts.

A Traditional IRA and a Roth IRA are similar.  The primary difference between the two is that a Traditional IRA allows for people to invest pre-tax dollars (meaning you get to deduct your contributions from your taxable income) while a Roth IRA allows for you to deposit post-tax dollars.  It would seem that the Traditional IRA is the way to go, but it’s not about how the money goes in, it’s about how it comes out.  With a Traditional IRA you are taxed accordingly when you withdraw the money during your retirement.  The Roth IRA allows you to withdraw your money without paying tax on it (you already paid the taxes when you earned it via income tax).  It’s this tax advantage that makes a Roth IRA a very smart investment choice for everyone, especially young people.

So you are in your early 20s and asking yourself, why should you worry about retirement, it’s 40+ years away?  It’s these years that are the most important for investing for your retirement.  I have two examples for you and then I will explain a bit more about the benefits of a Roth IRA.

Example 1: If you invest $5000 into a Roth IRA at the age of 25, and you let your money sit in that account and compound interest for 40 years until you retire you will have $108,000 in the account when you retire.  That’s right, $5000 today can equal $108,000 in the future assuming an annual growth rate of 8% (this percentage is the historical annual growth rate of the market).

Example 1 – Contribute $5000 at age 25 and watch it become $108,000 40 years from now

Example 1 – Contribute $5000 at age 25 and watch it become $108,000 40 years from now

Example 2: In this example, person A (the blue line) contributes $5000 a year into their Roth IRA starting when they are 25 years old. They contribute for ten consecutive years ($50,000 in total).  Assuming the same 8% returns as above they will have a nest-egg of $837,000.   Person B starts contributing to their Roth IRA at age 35.  They put $5000 a year into their Roth for the next 30 years ($150,000 in total).  That individual ends up with around  a $617,000 nest egg.

Example 2 – Person A Contributes $50,000 from age 25-35, Person B contributes $150,000 from age 35-65.  Person A ends up with over $800,000.  Person B ends up with around $600,000.  The Power of Investing Early!

Example 2 – Person A Contributes $50,000 from age 25-35, Person B contributes $150,000 from age 35-65. Person A ends up with over $800,000. Person B ends up with around $600,000. The Power of Investing Early!

Person B isn’t in bad shape by contributing to their Roth IRA starting at age 35, but Person A has the upper hand by starting 10 years earlier.  Person A contributed $100,000 less in after-tax money, and has an additional $200,000 to show for it, solely because they started earlier.  If you have the means, starting to contribute to your Roth IRA at a young age should be a priority.  (Head to Dinkytown’s Roth IRA Calculator to play with these numbers further)

Facts about Roth IRAs:

  • You can contribute up to $5000 if you file your taxes as a single adult and make less than $105,000.  (The income limits will be steadily increasing over time to keep up with inflation).
  • People over the age of 50 can contribute an extra $1000 into their Roth each year, meaning they can contribute $6000 a year.
  • You can withdraw your Roth IRA contributions at any time without fear of penalties or fees.  However, you will be required to pay a hefty percentage if you withdraw Roth IRA earnings before you are 59 ½.   This money is for your retirement!
  • You will not pay capital gains taxes on your earnings (your money is only taxed once with a Roth IRA, and that is from income tax).

With the uncertainty of Social Security being around for my generation, it is important to look towards retirement, and make sure we can enjoy our later years in style.  Person A in Example 2shows us why investing early is so important.  Our twenties and early thirties are the most valuable time to invest and will give you a head start on saving for your retirement and accumulating wealth.  To think, $5000 today could be $110,000 years from now.  This is the classic characterization of having your money work for you.

To find out more information about a Roth IRA, please click here.  To learn about where I set up my Roth IRA and how it is invested, please take a look at my post on Optimizing My Own Accounts – Making My Money Work for Me.  If you have any questions about Roth IRAs or other retirement vehicles, feel free to contact me or leave a comment.

12 Responses to Turning $5,000 into $110,000 (Tax Free) – All it takes is time
  1. Brook
    July 7, 2009 | 11:33 am

    I stopped contributing to my Roth IRA two years ago when I left my job to go back to school full time. I’ve since graduated, and I’ve been employed for several months. I was putting off contributing to my Roth, really out of procrastination and laziness more than anything else. Anyway, thought you’d like to know that your good influence propelled me to reestablish my contributions so I’m on target to max out by the end of the year. Thank you &ndash and keep writing!

  2. Brian
    July 8, 2009 | 4:02 pm

    @ Brook – Thats great to hear that you started up again. It sounds like you missed out on the bad stretch of the market coincidentally, so you may be well ahead of all of those that dollar-cost-averaged their way through the recession.

  3. JerichoHill
    July 16, 2009 | 8:17 am

    Hey Brian,

    One problem with your math is that you are not considering the cost of inflation, which would greatly reduce the real value.

    It is certainly possible to turn 5K into 110K over 25 years, but inflation adjusted the gain is much less.

  4. Brian
    July 16, 2009 | 10:29 am

    @JH – I agree, this does not account for inflation. However we do not know what inflation will be like over the course of the next 40 years, which makes it difficult to account for. We could knock off 3% of each annualized return to cover inflation, however $110K in 2050 is still $110K even if its only worth $75K in today’s dollars. Besides, doesn’t the sound of $5000 turning into something that is in the six figures just sound better?

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