I opened my first Individual Retirement Account (IRA) when I was in my twenties. I realize I’m going to date myself, but it was back when interest rates were double digits. I still recall how excited my husband and I were when we each invested $2,000 into our IRAs.
A traditional IRA is basically an account that allows you to set funds away for retirement while the money grows tax-deferred, meaning you won’t have to pay income taxes on it until you take it out. If you qualify, you can deduct that investment from your income on your tax return. It’s a pretty cool deal – especially if you start saving when you are very young.
As Albert Einstein supposedly said, “Compound interest is the eighth wonder of the world.” Whether or not Einstein uttered these words, the fact is, compound interest is indeed the secret to building retirement wealth.
Miracle of Compound Interest:
Let’s take a look at the miracle of compound interest:
Sarah opens an IRA with $2,000 at age 19 and stops when she turns 26 with a total investment of $16,000.
Melissa waits to start a retirement plan until she is 27 and continues to save until she turns 65 with a total investment of $76,000.
At age 65:
- Sarah has accrued $2.2 million
- Melissa has accrued $1.5 million
Why is this? It’s because of the power of compound interest and starting early!
Those IRAs that my husband and I started at age 26, would be worth $28,000 today each at a 10% return. This is just one terrific way to accumulate wealth. I would suggest using a much lower compounding rate like 5 or 7%.
Try this exercise using your own savings amount, number of years for saving and a lower interest rate on David Bach’s Latte Factor Calculus at www.davidbach.com/lattefactor
There are THREE mistakes I see people make with their IRA accounts:
- The first mistake is to simply not have one. One of the big issues I frequently with many women is that they love to make money and they love to spend it. Saving, let alone investing, is not a big agenda item. If you are earning money and do not have a tax-deferred retirement plan, I suggest you run … not walk to a financial planner or your bank and immediately set one up. You can talk to the adviser about which type of IRA best fits your needs because there are several to choose from, including the Roth IRA which does not get a tax deduction but still grows tax-deferred and the income comes out tax-free. Your adviser can also help you select an appropriate investment vehicle for the IRA account. Sometimes you can set these up with very little money and even add as little as $100 per month. The key is to just get started.
- The second mistake is not being diversified. Again, get some advice on how to invest your money. In a nutshell, there are mutual funds which are basically a divertive portfolio of stock, bonds, or other investments managed by a professional and then there are Exchange Traded Funds (ETFs) that operate like a mutual fund by giving you diversification, but they are not managed and have much lower internals fees. The goal is to have a variety of investments based on your age and risk tolerance. In addition, you want to look at the investment cycles. Bonds have been on a 30-year Bull cycle because of falling interest rates. Investing in bonds during this time can actually be very risky because when interest rates go up, bonds can lose a lot of value. So please get some advice from an expert and then re-balance your portfolio annually.
- The last mistake people make is with their beneficiaries. When I reviewed my Self-Directed IRA account, an IRA where I own real estate and a non-publicly traded stock. When I opened the account, the IRA custodian was called Entrust. A few years later, Entrust was taken over by Quest IRA. To my surprise, Quest did not have my beneficiary designation on file. It always makes me chuckle when something like this happens to me because I am a Certified Financial Planner and should know better, right? With all the consolidations and mergers, it’s really important to update those beneficiary designations. With proper beneficiary designation, IRAs can avoid probate, and in many cases when structured appropriately, the tax benefits can roll over to the recipient at death. If the beneficiary designation is not correct, it can have dreadful tax consequences.
My three IRA tips in a nutshell: Start one — Diversify — Update those Beneficiaries.
*Be sure to consult your tax advisor before investing in an IRA. If you have any questions feel free to make a comment or schedule a complimentary consultation with me at www.talkwithkatana.com