How Much Does a Roth IRA Make In a Year?
Owners of Roth IRAs generally see returns of 7% to 10% annually which is typical of a portfolio consisting of a blend of stocks and bonds. The real value of Roth IRAs, however, is the opportunity they provide for tax arbitrage and tax diversification within a retirement portfolio.
This is another installment in our “People Also Ask” series. Throughout this series of posts, we’ll be responding directly to popular personal finance questions submitted directly to popular web search engines.
Before we answer this question, we should make one important clarification.
Roth accounts, be they in 401(k)s, IRAs, 403(b)s, or 457 plans, do not “make” any more money in a given year than a Traditional or taxable account holding a variety of investments.
There are no legal restrictions or allowances that create a better opportunity to produce return from a Roth account than any other account that holds investments.
Rather, a “Roth” is a type of account that receives special tax treatment as compared to other investment options.
There are three basic investment account types:
- Traditional or Tax-Deferred – These accounts allow for contributions to be made before they are taxed. This means more of your hard-earned dollars avoid the burden of taxation and more principal can be invested for growth. Taxes are paid on the withdrawals made from these accounts.
- Roth or After-Tax – These accounts are funded with money that has already been taxed, but all withdrawals, including earnings, are completely tax-free.
- Taxable – Both contributions and earnings are taxed in these accounts. The most common of these is a taxable brokerage account that one might have at a major investment company like Vanguard or Fidelity.
Many times, I’ve heard these accounts metaphorically described as envelopes that investments sit in.
The investments inside are the same, but when contributions are made to or withdrawals are taken from these “envelopes”, the tax treatment will be different.
So How Much Money Does a Roth IRA Make?
Now, getting back to the original question, how much money does a Roth IRA make?
This depends completely on what investments are held in the account which is driven by one’s goals for return and managing risk.
Generally speaking, the more risky an investment is, the higher the potential for returns should be. Conversely, the lower the risk, the lower the likely return.
You can pretty well count on this because of the efficiency of markets and the intelligence of investors.
For example, you can currently go buy 6-month Treasuries (T-Bills) for an annual yield of 5.05%. These bonds are backed by the United States government which is about as low-risk as it gets.
Suppose you’re an investor trying to decide between two securities. One is a corporate bond with a yield of 5% and the other is the T-Bills yielding 5.05%.
You’d be a fool to buy the corporate bonds because they come with a higher degree of inherent risk. After all, if the corporation selling the bonds goes out of business the bonds would be worthless.
If the U.S. Treasury goes out of business, then we all have bigger issues than our portfolio situation.
The corporations are going to need to bump up that yield if they want to entice people to buy it.
Of course, evaluations are rarely that simple. There are thousands upon thousands of investment options so you’re generally better off deciding what your goals are before you hone in on a specific investment.
As a rule of thumb, fixed-income and savings instruments like bonds, money markets, CDs, and treasuries are more conservative while equity products based in stocks have a higher risk profile.
And, as you might expect, the long-term returns for stocks are normally higher than bonds.
Typically, the younger you are the more risk you can tolerate.
It’s not uncommon for young investors to be allocated 100% in stocks and the “going rate” for retirees is an asset allocation of 60/40 stocks to bonds (though everyone’s different).
My favorite index to quote on this site is the S&P500 which is made up completely of stocks and has averaged a return of 10.67% annually since its inception. You can buy an S&P500 index fund and should expect similar pre-tax returns.
Meanwhile, bonds have historically yielded returns of 5%-6% annually, though in the last decade they have only averaged 1.6%! This doesn’t even keep pace with inflation which is pretty disappointing.
Over the last 30 years, a 60/40 portfolio has averaged returns of 7.92% annually.
In summary, a 100% stock portfolio yields an average return of around 10.5% while a 60/40 portfolio will yield just under 8%.
(But that doesn’t mean you should always be 100% stocks either.)
Tax Arbitrage
We touched on the tax arbitrage benefits of Roth IRAs earlier and I’d like to briefly explain that if I may.
Because Roth and Traditional accounts allow you to choose when you will be taxed on the contributions you make into the account, you get a little control over how much tax you pay for the money invested in these accounts.
For example, let’s assume you are 24 years old and just getting started in your career. Your salary puts you in the 12% tax bracket, but your industry is growing and you expect your income to increase over time.
By the time your retire, you expect to be making withdrawals in the 24% tax bracket.
If you invest in a Roth account now, you’ll spare 12% of every dollar from taxes that would have otherwise gone to Uncle Sam.
That is tax arbitrage.
Of course, you don’t have to be young to do this. You can strategically take advantage of this opportunity from any age or economic demographic by understanding the differences between Roth and Traditional accounts.
Also, if you reverse the plan and assume your income taxes will be lower when you retire, a Traditional account would be advantageous over a Roth 401(k) or IRA.
Tax Diversity
Another benefit of leveraging these different types of accounts is the tax diversity they provide.
When you retire you probably won’t have much, if any, earned income.
Most of it will probably be a combination of social security, pensions (if you’re lucky), and some combination of the three investment accounts we referenced above (Traditional, Roth, and Taxable).
Because the tax treatment of these accounts are all different, you can use income from each account type strategically to control your realized income and thus, your tax exposure.
Let’s look at another example.
Suppose you worked for a local utility throughout your professional life and in retirement you’ll enjoy annual Social Security income of $30,000 and a pension of $40,000.
You and your spouse have annual spending needs of $100,000, so you’ll need to supplement your income with $30,000 each year from your investment accounts to cover the difference.
In 2023, if you can keep your taxable income below $89,450 your marginal tax rate will stop at 12% instead of jumping up to 22%.
So, for the last $30,000 you need you decide to take the first $19,450 out of a Traditional IRA which is subject to income tax on the entire withdrawal.
For the final $10,550 you pull from your Roth IRA so your tax exposure doesn’t increase from 12% to 22% for this final ten grand.
Ultimately, this tax diversity strategy will save you 10% of $10,550 which is $1,055.
Conclusion
Roth accounts don’t really make money, but the investments they hold do.
If you want to learn more about investing in tax advantaged accounts, I recommend you check out Milestone 2 and Milestone 5 on the Next Dollar Roadmap.
There are also scores of helpful posts you can find using the search field in the top right corner of your screen.
