The Roth IRA is widely lauded as one of the best ways to save for retirement, and for good reason. While the contribution limits are fairly low, steady deposits to a Roth IRA can make a world of difference when it comes to building tax-exempt savings. Still, many prospective retirees make a key mistake in the process, and it's absolutely critical that you aren't falling victim to this common error.
Here, we'll review the biggest -- and most expensive -- mistake you can make with your Roth IRA.
How a Roth IRA works
The Roth IRA allows savers to sock away a certain amount for retirement every year. The hope is that the money will continuously compound over the years, earning both price gains and dividend distributions along the way. What's more, the contributions you make to a Roth IRA are after-tax, which means that when you go to withdraw the money in retirement, you won't have to worry about any additional tax liability.
But the key thing to remember is that the Roth IRA is a tax-advantaged account -- not an investment unto itself. The Roth IRA is a great place to hold stocks or funds with high growth prospects, since the future value of your investments won't be subject to tax of any sort (assuming you've held the account open for at least five years). So be sure to actually invest your money!
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The costly Roth IRA error
As mentioned earlier, the Roth IRA is an account, not an investment. Many savers will deposit money into their respective Roth IRAs and think their work is done. In reality, you need to be absolutely sure that you take the second step of investing the money. Leaving your Roth IRA contributions in cash is an exceedingly costly mistake, and can seriously hamper your retirement savings' growth prospects.
Here, we compare the growth of $10,000 in a Roth IRA. In one scenario, the account owner leaves their contributions in cash (shown below as the Vanguard Federal Money Market Fund (NASDAQMUTFUND: VMFFX)), yielding no more than a few percentage points per year. In the other scenario, the account owner invests their money in the Vanguard Total Stock Market Index Fund (NASDAQMUTFUND: VTSAX).
VMFXX Total Return Level data by YCharts
As you'll note, the investor who remembered to invest their money in the wider stock market had an account balance of nearly $80,000 at the end of the 20-year measurement period, while the investor who left their money in cash was left with only about $13,000 for retirement. The difference is even more vast if we were to examine the effect of annual contributions to the account.
This is all to say that contributing money to your Roth IRA is half the battle. You also need to remember to put your money to work. The debates as to how the money should be invested are vast and complex; if you're unsure about how to invest your money, consider starting with a broad market, low-cost index fund that contains many companies of different sizes. The fund mentioned above, the Vanguard Total Stock Market Index Fund, is a solid place to start.
Don't shortchange your retirement
Given the sharp increase in costs we've all experienced over the last few years, it's imperative that you do everything you can to get the most out of your retirement savings -- especially in tax-advantaged space. Once you contribute money to your Roth IRA, remember that that's only half the battle, and you'll need to actually invest your money to give it the opportunity to grow. If you're unsure about how to proceed, seek the help of a qualified financial professional who is appropriately credentialed to dispense advice.
