If you want to retire a millionaire, funding an IRA is a great place to start. IRAs, or individual retirement accounts, are an invaluable investing tool because they're tax-advantaged. Plus, because they're set up and funded by you as an individual, you can save for retirement independently of your employer.
Whether you're funding a Roth IRA, a traditional IRA, or a combination of both, you're allowed to contribute up to $6,000 a year in 2020. If you're 50 or older, you can make an additional $1,000 catch-up contribution, so your limit is $7,000. Here's how long it would take you to become a millionaire if you maxed out your IRA every year using the 2020 limits.
How long does it take to become an IRA millionaire?
Let's suppose you started maxing out your contribution every year at age 22 by dollar-cost averaging $500 at the beginning of every month. You earn annualized returns of 8%, which is just below the S&P 500 post-inflation average for the past 40 years.
You'd reach millionaire status at age 55, after 33 years and four months of contributions. That's also assuming you didn't make $1,000 catch-up contributions when you turned 50. Of course, that's using the 2020 limits. They're adjusted for inflation in $500 increments, so it's safe to say you'll be able to contribute more over time -- though you'll also have to save well over $1 million to have the same purchasing power a millionaire would have in 2020 dollars.
It's also important to consider that the 8% return estimate is based on S&P 500 index average annualized returns from 1980 to 2020. Past performance doesn't guarantee future results. The level of risk you take when you invest also has a major effect on your returns.
Roth vs. traditional IRA: It makes a big difference
Becoming a Roth IRA millionaire is a lot different from becoming a traditional IRA millionaire. With a Roth IRA, you don't get to deduct your contributions for taxes. But the money is 100% tax-free when you withdraw it once you're age 59 1/2, provided that you've had the account for five years. (You can withdraw the contributions, but not the earnings, whenever you want without paying taxes or a penalty.) A traditional IRA gives you an upfront tax deduction on your contributions in most cases. But you still owe income taxes when you withdraw your money in retirement.
In short, being a Roth IRA millionaire means you have $1 million that's all yours in retirement. Being a traditional IRA millionaire means you have $1 million, but the IRS is still going to demand its cut.
If you expect to be in a high tax bracket when you retire or you're worried about tax rates rising, choosing a Roth instead of a traditional IRA makes sense, provided that you qualify based on the Roth IRA income limits. If you earn too much to fund a Roth, you could use a strategy called a backdoor IRA, where you fund a traditional IRA and then convert it to a Roth. You pay any applicable taxes in exchange for that tax-free nest egg later on.
Should you max out your IRA?
If your employer offers a 401(k) match, contribute enough to get the full match before you fund your IRA. Paying off high-interest credit card debt and building an emergency fund that can cover you for three to six months first are also good moves.
Once you've done these things, aim to max out your IRA contributions. You'll have a lot more investment options and general flexibility because you control the account, not your employer.