How Does My Money Grow in a Roth IRA?
A Roth IRA is an investment account that holds the investments selected by the account owner. The investments are what potentially cause the balance of a Roth IRA to increase.
For a number of reasons that we won’t discuss in this post, financial vocabulary and jargon can be abundantly confusing.
Possibly adding to the confusion are knuckleheads like me writing posts about financial topics while also making broad assumptions about how well-versed our readers are on the financial lingo.
In fact, we tend to overlook some very fundamental topics in the quest to untangle more complicated issues for our readership.
For example, one key concept any investor should understand are the basic differences between common investment tools such as: 401(k)s, IRAs, Stocks, Mutual Funds, Roth’s, Bonds, ETFs, etc.
In this mixed bag of financial terminology are two fundamental investment categories that we want to distinctively highlight and explain further in this post.
Understanding the primary difference is a key step toward organizing one’s portfolio for maximum success.
Investment Returns
To begin with, let’s answer the question at hand: “How does my money grow in a Roth IRA?”
The most basic answer I can provide is through investment returns.
Your Roth IRA balance will grow by selecting an investment or, preferably, a pool of investments that increase in value over time.
These investments can be things like stocks, bonds, mutual funds, Treasuries, ETFs, money markets, and certificates of deposit (among other possibilities).
Please click on the hyperlinks for further information about the topics we’ve explained in other posts.
Summarizing here, all of these investments gain or lose value based on a host of economic factors.
In the case of stocks, and stock-holding mutual funds and ETFs, value is determined by the trading value of the shares of the companies owned by each security.
Bonds, CDs, Money Markets, and Treasuries are mostly debt-based assets, meaning you act as a lender when you purchase the various securities.
Debt investments tend to have more stable returns, but they are not without risk. Although, treasuries are about as close to a risk-free asset as you can get.
For the sake of explaining the difference between these securities with other financial items, we will metaphorically call securities our “contents” and the accounts they go in will be called “containers”.
Containers & Contents
Anyone can purchase the securities we have mentioned above, but there are several different ways to buy them.
The reason we have multiple paths for buying these investments is that the tax treatment of each one is different.
We’ll call these our “containers”.
One of the better metaphors I’ve heard used to describe this is to imagine a house. An account like an IRA or a 401(k) is like an empty house.
Investments like stocks, bonds, mutual funds, etc. are the furnishings.
So, the house/container is the account type and determines the tax treatment, while the investments/contents are what actually produce earnings and growth within the account.
There are three basic account types:
Taxable
Taxable accounts are containers that are funded with money that has already been taxed. Withdrawals from taxable accounts are also fully taxable.
In summary, there are no special tax advantages for taxable accounts.
Once the account is funded, the money can be used to purchase any number of the securities we’ve previously mentioned (the contents).
Taxable accounts are most often standard investment/brokerage accounts anyone can open with an investment company like Charles Schwab, Vanguard, or Fidelity.
Tax-deferred
Tax-deferred accounts are containers that are funded with money that has not been taxed. However, all withdrawals from a tax-deferred account are taxed at regular income tax rates in the year the withdrawal is made.
The tax benefit of tax-deferred accounts comes in the form of earnings that can grow for years without being hindered by the drag of taxes.
Once the account is funded, the cash in the account can be used to by any of the securities/contents we mentioned above.
The most common types of tax-deferred accounts are Traditional IRAs, 401(k)s, 457s, and 403(b)’s.
After-tax
After-tax accounts are funded with dollars that have already been taxed, but withdrawals from after-tax accounts can be made completely tax free.
The tax benefit of these accounts is the way earnings are allowed to grow and be withdrawn completely tax-free.
Again, nearly any security can be purchased in the after-tax container.
The most common types of after-tax accounts are Roth IRAs, Roth 401(k)s, Roth 457s, and Roth 403(b)s.
Here’s a list again to help you visualize account types (containers) and securities (contents). Bookmark this page or copy this table somewhere handy if you need help remembering.
Containers | Contents |
IRAs | Stocks |
401(k)s | Mutual Funds |
HSAs | Bonds |
457s | ETFs |
TSPs | CDs |
403(b)s | Money Market Funds |
Roth version of any aforementioned container | Money Market Accounts |
529 College Savings Plans | Treasuries |
Wrap-Up
Understanding the differences between account types and security types is important for ensuring you select an investment portfolio that suits your needs.
We hope this has been helpful.
I’d encourage you once more to follow the hyperlinks in the various investment types above. We’ve written a lot about these topics and there’s plenty to learn.
I’d also recommend you check out our Next Dollar Roadmap. It would take a while to read all 10 posts, but it’s an excellent primer on where you stand financially and how you should prioritize your next steps.
