This post goes out to my friend, who knows who he is, since I failed to convince him to fund his Roth IRA recently. For young people early in their career like him, the compound interest from time in the market is the most powerful investment tool at their disposal. So I’ve decided to write an entire post just for him, to convince him to fully fund his Roth IRA for 2020 and 2021 instead of buying another car. Here’s my mindset behind basic retirement investment and how we can all harness the power of compound interest.
Financial Order of Operations
There is a whole order of operations for personal finance, similar to math. I won’t go too far into this topic here, since I want to mainly focus on Roth IRA funding. However, the first personal finance priority is paying off high interest consumer debt, such as credit card debt. High interest student loans count too. Mr. Money Mustache describes this kind of debt as a financial emergency, and he’s completely right. While his debt repayment plan of “don’t spend on anything nonessential before your debt is gone” is too extreme for some people, I can’t argue with its efficacy. I highly recommend paying off all high interest debt before investing.
Why You Should Max Out Your Roth IRA
That brings me to the ultimate reason for this article: why you should max out your Roth IRA. The answer is compound interest. For long term investment, time in the market with smart investments is critical. I was trying to convince my friend to max out his Roth instead of buying an extra car. So I’ll make the example specific, let’s say you max out your Roth IRA for 2020 and 2021. That’s a deposit of $12,000. Then you wisely invest in a total stock market index fund and let it ride for 40 years until retirement. I think index fund investing is the most sensible for regular investing (as I’ve learned from experience). The market does its thing for those years: it goes up, sometimes goes down, but ultimately goes up. This isn’t a guarantee, but like JL Collins, I choose to be optimistic. So what will this money become in 2061?
I put in three different scenarios: the average stock market returns of 8% and two smaller yearly return percentages. In all the cases, this $12,000 alone has an incredible yield. I’ll remind you that since Roth IRA’s are funded with post-tax dollars*, all of this extra money is tax free. I can’t think of many legal ways to receive $100k tax free, but here it is available to anyone who funds their Roth IRA. If you continue to fund your Roth IRA every year, at the end of 40 years at 6% returns you will have over $1 million. And that’s all by doing no extra work!
I’m Begging you, Max out your Roth IRA
I hope I was able to convince you to scrimp and save in order to fund your Roth IRA. The raw numbers show that it should be a huge priority to save in any way possible. And time is truly of the essence. If you wait 10 years to start funding your Roth IRA, at retirement age you will only have about $500,000. Waiting 10 years costs you half of your potential retirement. So I’ll ask you one one more time Kenny, put off buying that extra car and fund your Roth IRA.
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*I accidentally stated that Roth IRA’s are funded with pretax dollars. What I meant is that since you’ve already paid taxes on the money that enters the Roth IRA, the money that you take out at retirement age is withdrawn tax free. Thanks to a reader for pointing out the error!
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