A 401(k) is the most common retirement account, but it's far from the only type of retirement account available. Another common account is an IRA. Unlike a 401(k), an IRA isn't tied to an employer and must be opened independently, similar to a bank or brokerage account.
There are two main types of IRAs: traditional and Roth. Both have unique benefits and can play a critical role in your retirement savings and investment strategy.
It's natural to want to boost your IRA balance as much as possible to prepare for retirement, and many people set their eyes on the million-dollar mark. And while that's a great goal, people should keep a few things in mind.
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1. IRAs have low contribution limits compared to other retirement accounts
IRAs have many great aspects. They're free, allow you to invest in virtually any stock or exchange-traded fund (ETF) you want, and have flexible early withdrawal rules that can be beneficial for life events like buying a house or paying for higher education expenses.
That said, one downside to an IRA is the relatively low contribution limit. The most you can contribute to an IRA in 2024 (both traditional and Roth combined) is $7,000. If you're 50 or older, you can add an additional $1,000 catch-up contribution, bringing the limit to $8,000.
IRA contribution limits are far lower than a 401(k), which allows you to contribute $23,000 ($30,500 if you're 50 or older). This is important to keep in mind when aiming to become an IRA millionaire.
2. Compound earnings is the greatest gift on your side
Because of IRAs' relatively low contribution limits, the key to hitting the million-dollar mark will rely heavily on time. Time is one of the greatest forces in investing, mainly because it fuels compound earnings. Compound earnings occur when the returns you earn from investments begins to generate returns of their own.
For example, imagine you invest $1,000 and earn a 10% return, or $100. If you reinvest the $100 and receive 10% again, you're now earning a return on $1,100, receiving $110. If you reinvest the $110, the 10% is now on $1,210. It's a rewarding cycle that can take relatively small investments and turn them into big gains.
For compound earnings to work its magic, though, it needs as much time as possible. The more time, the more the compounding effect grows. Without compound earnings, it'd take someone over 142 years to hit $1 million by saving $7,000 annually and 125 years by saving $8,000 annually.
3. You'll need at least a couple of decades on your side to make it happen
Those aiming to become IRA millionaires should be prepared for the journey to take at least a couple of decades, and that's on the lower side of things. For perspective, the S&P 500 (^GSPC 0.80%) -- which is the stock market's primary benchmark -- has averaged around 10% annual returns since its inception. In the past decade, it has averaged 12.7% total returns, so we'll round that up to 13% for our example.
Assuming the IRA contribution limit remains at $7,000, and you invest that amount while averaging 13% annual returns, it will take you close to 25 years to cross the million-dollar threshold. If you started at 50 and contributed $8,000 the whole time, it'd still take you close to 24 years.
It's important to note that past results don't guarantee future performance, and returns can vary widely -- especially over decades. You could average 10% annual returns over those years, or you could average 15%. Nobody can say for certain.
That's why the main focus should be on starting as early as possible and prioritizing maxing out your IRAs each year. I always recommend that people contribute enough to their 401(k) to get the maximum employer match and then focus on using any additional money to fund their IRAs.
Once your IRA is maxed out for the year, return and add additional contributions to your 401(k) if you choose. That strategy gives you the best of both worlds.
