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Update #2: I also answered a question from the comments below in a different post. It addresses Roth IRA minimums.
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I’ve got a keen interest in learning more about how changing one thing in your life can have a huge impact further down the line. More on that in the future.
The Roth IRA is one of those changes. One simple decision that can truly change your life.
The government allows you as an individual to set aside $5,000 (as of 2008) per year of after-tax money for your retirement. I decided to use the Roth for this example because it eliminates taxing gains on your investment, which makes the example a lot more simple.
So what happens if you start early and set aside just $5,000 per year?
Let’s run the numbers.
Using Excel, you can calculate what amount of money you would end up with based on the following criteria. I’m using myself as an example because, well, I know everything about me.
- Age: 24
- Retirement: 66 (I would rather retire earlier than this, but am willing to work this long)
- Annual Contribution: $5,000 after-tax dollars
- Annual rate of return: This can vary greatly. We’ll stick with a very conservative 7% per year.
You can make changes and run your own calculations with my Roth IRA calculator (in Excel).
Long story short? If you start early, you can retire as a millionaire by just using one investment vehicle. No need for five different accounts with three different brokers. A simple Roth that through whatever investments you chose earns 7% per year, nets you $1.2 million (give or take some due to rounding error). You can see a chart of your cumulative contributions compared to the balance in the account. See how much you are earning at the end without having to put more money in — the beauty of compound interest. (You can click on the chart to see the full size.)
For those who like easy steps:
- Pay off debt, live a debt free life.
- Commit to putting away $5,000 after-tax money into a Roth IRA. That’s $416.67 per month.
- Invest in index funds like Vanguard’s Total Stock Market, Total International Stock Market, and Total Bond Market. Lower fees = higher returns.
- Earn a ‘measly’ 7% return on your investments each year until retirement.
- Retire with $1.2 million.
Want to run your own numbers? I’ve uploaded the handy Excel workbook for you.
Useful Links:
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5 Comments, Comment or Ping
chris.pund
You say the max is $5,000 is there a minimum? If I can’t afford to do the $416.67 per month, what is the lowest that I can go without any kind of penalty. Or can you go without putting anything in for a year or two, not that you would want to do that. Just curious, I’m not completely familiar with the way the Roth works. Thanks Kevin!
Apr 22nd, 2008
Mike
Roths are great, and I agree that they are an excellent way for many people to save. One addition to what you wrote is that anyone making more than $116,000 per year ($169,000 for couples) cannot contribute to a Roth (those are the 2008 limits). I know that sounds like a ton of money, but “middle-class” is now defined as households making less than $200,000 per year, so a lot of families do miss out on being able to use Roths.
Also, there are no guarantees that the government won’t tax the gains in the future, that’s just the law currently in effect.
Apr 23rd, 2008
Tom
While 1.2 Million might sound like a lot right now, I doubt that you will be able to live comfortably of the income it will produce when you reach 66. This is due to inflation. If you figure inflation at 3% you will only net 4% per year. If you put 4% per year into your calculator you will get a picture of what you will have in today’s dollars when you retire. The amount it produces is 545,000 Now take 4% of that a year (the other 3% will need to stay in the account to hold the purchasing power for the continued inflation you will experience) and you get 21,800 per year; a nice supplement to social security for sure, but hardly enough to consider yourself rich.
I commend you for taking an early interest in your retirement, but you may want to either contribute more over the years or go for a higher rate of return. At your age I would suggest being more aggressive up front and scaling back as you grow older and your nest egg grows. Many of the targeted date mutual funds do exactly that and may be a good choice for you.
Apr 23rd, 2008
Kevin
I’ll go back and edit the post, or write a follow up, that takes into account inflation.
However! If you contribute the -equivalent- of $5,000 per year each year, then at the end you will end up with the -equivalent- of $1.2 million.
So year 1 = $5,000
year 2 = ($5,000 x 1.03) for 3% inflation = $5,150
year 3 = $5,304 ($5,150 x 1.03)
etc. etc.
In the end you end up with a bigger number, but its equivalence is $1.2 million in today’s dollars.
Apr 23rd, 2008
Dave
Your inflation adjustment isn’t quite right. I modified your spreadsheet to increase the contribution by 3% each year and then converted the end result into today’s dollars and I came up with the same result that Tom calculated using a return of 4% ($545k). A return of 10% will get the post-inflation adjusted rate you are looking for.
Feel free to plug these equations into your spreadsheet if you aren’t convinced:
In E1, enter 0.03 as the inflation rate
In D9, replace your equation with “=D8*(1+$E$1)” to increase the contribution by 3% each year, and copy that equation down to the bottom.
In I8, type “=H8/((1+$E$1)^(B8-$B$8))” which will give your ending balance in today’s dollars and copy down.
You’ll see the final result is $544,711.70 for an interest rate of 7% and an inflation rate of 3%. This is approximately the same value you get if you use an interest rate of 4% and an inflation rate of 0%.
I agree with John that this is a great start, but it should be supplemented with additional retirement savings, like taking advantage of the company’s match on a 401(k). I appreciate the advice you are giving. I’m afraid that when people in their 20s and 30s reach retirement age, a lot of them are going to wish they could go back and start saving aggressively as early as possible.
Apr 29th, 2008
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