Learn from the master: That's good advice whether we're talking about developing negotiating skills, golfing, or playing the violin. It's also applicable to investing.
In the investing world, there are few (if any) greater masters than Warren Buffett. I think that applying the wisdom he has imparted through the years can enable some disciplined investors to amass fortunes over time. Here's how maxing out a Roth IRA with Buffett's favorite exchange-traded fund (ETF) could make you $1.3 million.
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Answering three key questions
You probably have some questions after reading my bold claim. Let's address three of those key questions right out of the gate.
First, why is a Roth IRA a good alternative for investing your money? The answer is simple: It provides a way to grow your portfolio tax-free. Yes, you'll have to pay taxes on your contributions. After that, though, you won't have to pay taxes on your retirement account ever. Over time, the gains from your investments should be greater than your contributions.
Second, how much do you have to contribute to max out a Roth IRA? For 2024, the maximum contribution is $7,000. That's an increase from $6,500 last year. However, if you're age 50 or older, you can add another $1,000 as a catch-up contribution. Your maximum, therefore, would be $8,000 in 2024.
Third, what is Buffett's favorite ETF? I believe it's the Vanguard S&P 500 ETF (VOO 1.00%). My selection of this ETF is based on two factors. His Berkshire Hathaway portfolio includes only two ETFs. Berkshire has a little more money invested in the Vanguard S&P 500 ETF, which makes me think it's probably Buffett's favorite.
More importantly, Buffett revealed in his 2013 letter to Berkshire Hathaway shareholders that his will instructed that most of the cash inherited by his family be invested in "a very low-cost S&P 500 index fund." He added, "I suggest Vanguard's."
Crunching the numbers
Now for the fun part. Let's see how you could make $1.3 million by maxing out a Roth IRA with the Vanguard S&P 500 ETF.
I'm going to use $7,000 as the annual amount invested since it's the standard maximum contribution for Roth IRAs this year. Keep in mind, though, that the maximum contribution is likely to increase. Also, as previously mentioned, you can contribute more money if you're 50 or over.
We also have to estimate what level of return you'll make. The average annual return for the S&P 500 between 1957 (the inception in its current form with 500 companies) and the end of 2023 is 10.26%. Since the Vanguard S&P 500 ETF tracks the S&P 500 index, let's use this percentage less the ETF's annual expense ratio of 0.03%. That gives us an average annual return of 10.23%.
Arguably the most important factor in our number-crunching exercise is time: how many years you'll invest. I'm going to use 30 years, which should be realistic for many people. Some will be able to max out a Roth IRA for a longer period (for example, starting at age 25 and continuing to contribute until you're 65 would bump up the number to 40 years).
Plug these numbers into a future value calculator. At the end of 30 years of investing $7,000 per year with a rate of 10.23%, you'd have (drum roll, please)... a little over $1.3 million. By the way, if you invested for 40 years, your portfolio would increase to more than $3.6 million. On the other hand, after investing for 20 years, you would only have around $450,000. As I said, time is important.
Two caveats
Easy peasy, right? I'd say so, but there are a couple of caveats.
There's no guarantee that the Vanguard S&P 500 or the S&P 500 itself will be able to achieve the level of returns generated historically by the index. On the other hand, it's possible that the average return could be even greater than the historical average.
Inflation also can (and almost certainly will) diminish the buying power of your money over time. You might have $1.3 million after contributing the maximum to a Roth IRA for 30 years but not feel like a millionaire because prices have risen so much. Increasing the amount you contribute to match the maximum level as it increases could help offset some of the impact of inflation, though.
That said, I think that maxing out a Roth IRA each year for as many years as possible is an exceptionally smart move. I also agree with Buffett about the wisdom of investing in low-cost S&P 500 index funds such as the Vanguard S&P 500 ETF. Over time, your money should grow tremendously. You could even look like an investing master one day.
