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Updated on Thursday, December 10, 2020
A Roth IRA can be an excellent way to set money aside for retirement, but knowing how to make your money grow in a Roth IRA can be confusing.
The first thing to understand about Roth IRAs is that they don’t have their own interest rates. Roth IRAs, like traditional IRAs, are investment vehicles, which means their interest rates depend on the investments placed inside them.
So how do you decide on the best investments to put into your Roth IRA to maximize your interest rate? Unlike a savings account, money market account or certificate of deposit (CD), getting the best rate from your Roth IRA requires more than shopping around to find a competitive rate. Instead, you’ll need to be intentional about the investments you choose for your Roth IRA.
Sound confusing? It doesn’t need to be. Here’s what you need to know about getting the greatest returns from your Roth IRA.
What is a Roth IRA?
A Roth IRA, like a traditional IRA, is a tax-advantaged retirement account. Both have a contribution limit of $6,000 for 2021 ($7,000 if you’re age 50 or older), and your money grows tax-free inside both account types.
The biggest difference between Roth and traditional IRAs is how each type of account is funded. Contributions to traditional IRAs are tax-deductible, but withdrawals are taxed as ordinary income. Roth IRAs, on the other hand, are funded with money that already has been taxed, which means you won’t pay any taxes when you access the funds in your Roth IRA as long as you wait until after the age of 59 and a half to take distributions.
Roth IRA returns
Because of compound interest, the best way to ensure good returns on your Roth IRA investments is to maximize your annual contribution.
For instance, let’s say you are 30 years old and open a Roth IRA. You decide to put aside the maximum contribution of $6,000 per year. You earn 8% interest, which is compounded annually. After 35 years of saving this way, you will be able to retire at age 65 with over $1.12 million. Not bad!
But what if you don’t start at age 30? Suppose you wait to open a Roth IRA until you are 40 years old but still contribute the annual maximum of $6,000 and earn 8% interest on your investment. You might assume that a 10-year difference won’t make much of an impact since you’ll still benefit from 25 years of compound interest, but you would be incorrect. The saver waiting until age 40 to start will have just under $480,000 at age 65.
Roth IRA interest rates and fees
Other than maximizing your annual contribution, the next best way to ensure your money keeps growing in your Roth IRA is to choose investments with minimal fees.
There are four common types of fees that affect Roth IRAs:
- Account maintenance fees are the easiest to avoid or minimize. Some firms charge an annual fee to account holders simply for having an account with them. Savers can shop around to find a brokerage firm or provider that does not levy such a fee or keeps its maintenance fees low.
- Trading fees or commissions occur when you buy or sell a stock or exchange-traded fund (ETF). These fees generally range from $5 to $20 per trade, and they can make active trading quite expensive. Savers can avoid these fees by adopting a buy-and-hold strategy.
- Mutual fund expense ratios are applied to cover the cost of managing the mutual funds your money is invested in. An expense ratio is paid for out of your invested assets and expressed as a percentage of your assets. For instance, if you invest in a fund with a 0.25% expense ratio, you will see $25 deducted from every $10,000 you invest. As is the case with maintenance fees, you can shop around to find a low expense ratio.
- Mutual fund loads are fees charged to the account holder for the cost of buying or selling shares. These loads can eat into your returns, but there are a number of high-quality, no-load mutual funds that will allow a saver to avoid this cost.
Where to open a Roth IRA
You can open a Roth IRA with a traditional brokerage or with a robo-advisor. Traditional brokerage firms generally are better for investors who are more hands-on, as they allow you to choose your investments. This can be as complex as hand-picking (and buying and selling) the stocks and ETFs you want in your portfolio or as simple as deciding which three or four mutual funds will give you the diversification you want. You can expect to pay trading fees and expense ratios with a traditional brokerage. A good traditional brokerage firm will have a number of low-cost investments for you to choose from and offer retirement planning tools and information to help you make the best choice for your investments.
Robo-advisors, on the other hand, will make these sorts of decisions for you. Once you provide your investment timeline, risk tolerance and goals, the robo-advisor will build and maintain a diversified portfolio for you. Robo-advisors generally charge a service fee that is a percentage of your assets under management — usually 1% or less, although many charge 0.5% or less. A good robo-advisor will keep its fees low and offer services like automatic rebalancing and tax loss harvesting to give you the biggest bang for your buck.
The bottom line
Investing in a Roth IRA will save you the headache of paying taxes in retirement, and you’ll be able to choose your investments, hopefully maximizing your Roth IRA returns.
It’s important to remember that returns on investments are not guaranteed. Anyone who wants a solid interest rate should consider high-yield savings accounts, CDs or money market accounts. However, the guaranteed interest you get from those options tends to be much lower than the kinds of returns you can expect to receive from your Roth IRA investments over several decades.