It's not uncommon for people to wait until the end of the year, or even until April of the following year, to make IRA contributions. That's certainly better than making no contribution at all, but this strategy may be hurting you in ways you hadn't expected. Making lump-sum IRA contributions at the end of the year could actually cause you to have a 10% lower IRA balance over 30 years, according to the Vanguard Group, compared to someone who contributed the same amount in monthly increments.
Why? It all comes back to compound interest. Below, I explain how that works and how you can harness its power to boost your retirement savings by up to 10% all without setting aside any extra money.
The power of compound interest.
You may be familiar with the idea of simple interest. Under a simple interest model, if you make a $5,000 investment that earns a 5% annual return, you will earn $250 each year. So after one year, you'll have $5,250. After two years, you'll have $5,500, and so on. But this isn't how IRAs work. IRA balances benefit from compound interest, which is different, and better!
Compound interest essentially means you earn interest on your interest. So using the same numbers as before, you would earn 5% on your initial $5,000 investment in the first year, so you would have the same $5,250 in the start of year two as in our prior illustration. But things change in year two. Now, instead of earning 5% on the initial $5,000 investment, you're earning 5% interest on the new, larger balance of $5,250. This will earn $262.50 in compound interest, bringing your total balance to $5,512.50. That may not seem like a huge difference over our previous example, but the effect gets greater with time. Over 30 years, that $5,000 investment could grow into $38,601, assuming a 7% annual interest rate.
So why does this matter for your IRA? Because the sooner you begin contributing money, the more time it has to sit in your account and compound. And the more the account is earning in compound interest, the less money you need to contribute on your own in order to meet your retirement goals.
Vanguard's research compared two different savers, both of who contributed $5,500 per year to their IRA for 30 years. One contributed this amount in a lump sum right before tax day, while the other contributed the same amount but in monthly increments. Both were assumed to earn 4% annually after inflation. After 30 years, the saver who contributed money in monthly increments had $15,500 more than the saver who contributed the same amount in a lump sum -- a difference of about 10%. And this amount could be even higher if the annual interest rate were higher, and the 4% used is rather modest, so it's likely to be even more in practice.
Increase your balance without increasing contributions.
If you're looking for a way to boost your IRA balance but you cannot afford to increase your contributions, setting up regular monthly payments is a smart move.
Decide how much you'd like to contribute each year and divide this amount by 12 to determine how much to contribute each month. Then, set up an automatic deposit to your IRA for this amount. Remember to be mindful of the annual contribution limits ($5,500 in 2018 and $6,000 in 2019, plus an extra $1,000 for adults 50 and older) so that you don't contribute more than the Internal Revenue Service (IRS) allows.
There are two advantages to this approach. First, it will increase the value of your account over time, as mentioned above. Second, it could enable you to contribute more than you otherwise would have had you waited until the end of the year, simply because it's easier to budget for. If you plan to make a lump sum payment at the end of the year and you aren't budgeting, you may find out you don't have much left over because you spent it all. But if you have a regular monthly payment worked into your budget, you won't have this issue. We all know the pain of running out of money and not meeting our savings goal.
It doesn't take long to set up an automatic payment, and it can make a big difference in your IRA balance over the long term. Plus, the predictable monthly expense can take some of the stress out of saving for retirement. So what are you waiting for? Reevaluate your current IRA contribution strategy today to maximize your savings for the future.
There's no time like the new year to take a different and better approach to retirement savings, and this simple trick is too easy to pass up.