how does a Roth IRA work?


I recently opened one and understand I can put money in all year up to $6000. I understand I can buy stocks, mutual funds, and ETFs. But how does it grow? How do the models show exponential growth?

In: 7

The account is simply a legal tax shelter. The investments you decide to invest in should grow over time due to what they own. The Roth IRA allows you to put after tax money in and let it grow completely tax free. If you’re young, it’s a great vehicle, as your distributions are tax free in a long time, when the money should have grown substantially.

It’s not any different from a regular IRA. You can invest in lots of stuff with the money. I recommend the Vanguard target retirement funds as they are diversified. In any case the only other gotcha is that a Roth has income limits, you have to have it for five years before the money is tax free and you have to put post tax money in it (meaning you can’t use the money to reduce your taxable income).

You can also use it for down payments on a house and college expenses for yourself or dependents without penalty.

Just keep funding it every year without fail. If you put the money into an S&P 500 index fund, it will out-perform 80% of the mutual funds out there. In time, and I mean in decades, you will seriously thank your younger self because it really grows. The time value of compounding returns is a beautiful thing. And when you’re 59-1/2 years old, you will be able to take tax-free distributions.

The stock market as a whole, over long periods of time, goes up. That’s just its nature. It grows exponentially because it goes up a few percent points every year. Let’s say you invest $1,000 and it grows 10% every year for five years. THAT’S NOT +$100 EVERY YEAR. That’s $1,000 -> $1,100 (+100) -> $1,210 (+110) -> $1,331 (+121) -> $1,464.10 (+133.10) -> $1,610.51 (+146.41).

The way investments work in whatever investment account (regular, ROTH IRA, traditional IRA, 401k, etcetera) is the same, what differs is taxes, contribution limits, withdrawals, etcetera.