How much interest does an IRA earn?
If you are considering opening an IRA, you may want to know how much interest IRAs earn. Here is everything you need to know.
If you use a traditional IRA to save for retirement, you are allowed to defer paying taxes on your contributions. The contributions you add to the account are allocated to various investment opportunities that earn interest. Here is what to know about the average IRA returns and how to maximize these earnings.
IRAs have historically earned 7% to 10% in average annual returns. Your earnings increase when you invest your IRA contributions and investment earnings into interest and dividend-earning opportunities like stocks, mutual funds, bonds, exchange-traded funds, and certificates of deposits. IRAs grow through compounding, which helps your money grow regardless of whether you contribute or not.
How does an IRA grow?
When you contribute to a traditional IRA, the contributions you make are expected to grow over your working years into a big nest egg. Here are the various ways that your IRA money grows:
An IRA is not restricted to employed workers only, and anyone can open an IRA. When you contribute to an IRA, the funds are allocated to various investments such as stocks, mutual funds, ETFs, etc. The investments you pick vary depending on your level of risk and investment goals.
Interest and dividend
The interest or dividends you earn depend on the investments you hold in your IRA. If you have a well-diversified portfolio comprising bonds, stocks, mutual funds, money market, and certificates of deposits, your investments will continually earn interest or dividends that are added to your IRA balance.
Apart from making IRA contributions and earning interest from investments, the main growth comes from compounding interest. The IRA contributions and investment earnings re-invested into the account earn an annual return of about 7 % to 10% each year the money remains in the account, regardless of whether you contribute or not.
How an IRA earns interest
Unlike a savings account that pays an interest rate, an IRA does not pay an interest rate. An IRA account can be compared to an empty basket that has to be filled with investment products such as stocks, bonds, ETFs, certificates of deposits, etc. to earn interest. Hence, the money you contribute must be invested in these high-growth opportunities to earn a return, which in turn earns more money through compounding.
By default, most IRA custodians place investor contributions in a money market fund. However, money market funds have low returns, and you must choose other investments to create a well-diversified portfolio. An IRA has a wider pool of investments than workplace retirement plans such as 401(k), and you can choose investments with the highest potential and low fees.
For example, if you are above 50, and you contribute $7,000 each year for 10 years, you would have saved $70,000, assuming there are no interest earnings during that period. However, if you contribute this amount to an IRA paying an interest rate of 7% annually, you will have accumulated $96,715 by the end of the 10 years. If you let the money grow for another 20 years, you will have accumulated $286,968 by the end of the 20 years.
What determines IRA interest?
Traditional IRAs have different interest rates, and the rate of return you earn depends on the investments you choose. The total earnings will be an aggregate of the performance of individual bonds, shares of mutual funds, stocks, ETFs, certificates of deposits, etc.
For example, if you invest your retirement contributions in shares of an index fund comprising stocks from multiple companies, your IRA earnings will reflect the performance of the market. When the stock market returns are high, you will profit from the high stock returns. However, if the stock market experiences a downturn, you will see a dip in your IRA earnings.
Depending on your age and years remaining to retirement, you can hold short-term securities with average earnings or hold high-risk securities with the potential to earn high returns but with a high risk of loss.
How to maximize IRA returns
Try these strategies to maximize your IRA returns:
Max out your IRA
One way you can maximize your IRA returns is to max out your contributions. You should contribute the maximum allowable contributions each year. For 2022, you can contribute up to $6,000 per year and an additional $1,000 in catch-up contributions if you are above 50.
Invest based on your time horizon
The investments you choose should be based on your time horizon. If you are young and you have many years to retirement, you can hold aggressive investments such as stocks that have a greater potential to earn high returns. You can invest in shares of a market index fund that diversifies your investments across many companies.
If you have a few years to retirement, you should move from aggressive to conservative investments. For example, treasury bonds are low risk, and they limit your losses if the market experiences a downturn, but it also limits your returns.