How to make millions using your IRA. – it’s possible if you start early.

IRA stands for an Individual Retirement Account and it is a tool designed by the IRS to help you save for your retirement in a tax advantaged way. By following the rules and starting early you can make millions using your IRA and be set for your golden years.

There are different types of IRAs – traditional and Roth, SEP and Simple.

Traditional: When you contribute to a traditional IRA you are reducing your taxable income at the same time. For example, if you earned $50,000 and contributed $5,000 then your taxable income would be reduced to $45,000. When you withdraw from a traditional IRA your withdrawal is considered to be normal income and is taxed as such. In this way you can defer the taxes that you would normally pay until your retirement. Ideally, you would be in a lower tax bracket and ultimately pay less taxes overall. Starting in 2019 you must begin taking at least minimum withdrawals when you turn age 72.

Roth: Contributions to a Roth IRA are made with after tax dollars so they do not reduce your taxable income in any way. The advantage with a Roth IRA is that withdrawals are tax free and there are no minimum withdrawal requirements at any age.

SEP IRA: SEP stands for “Simplified Employee Pension” and is available to any self-employed person. SEPs follow the same tax rules as traditional IRAs except they have larger contribution limits. (see below). A business owner can set these up for his or her employees and the business can make tax deductions based on their contributions. However, the employees are not allowed to contribute.

Simple IRA: Simple stands for “Savings Incentive Match Plan for employees” and it too follows the same taxation rules for withdrawals as a traditional IRA. Unlike SEPs however employees are allowed to make contributions and just like the business these are tax deductible contributions.

Contribution limits:

The IRS sets limits on the amount one can contribute to their IRA and this applies to both traditional, Roth, SEP and Simple IRAs.

In 2020 the maximum allowable contribution to a traditional IRA for those under 50 years of age is $6,000 per year. If you are over 50, then you may contribute up to $7,000 per year. These contributions must come from ‘earned income’ as defined by the IRS and you cannot contribute more than what you earned.

Depending on your earned income – if it is too high – you may only contribute to a Traditional IRA (and not a Roth). Single filers whose modified adjusted gross income is greater than $139,000 may not contribute to a Roth IRA, but may to a traditional. If you are married and filing jointly the limit is $206,000.

There are several rules around contribution limits that can be found in great detail on the IRS website here.

The contribution limit for SEP IRAs are up to 25% of your compensation (for 2020) or $57,000 whichever is less. The Simple IRA contribution limit (for 2020) is $13,500. If you are 50 years of age or older you may contribute an additional $3,000 which is considered a catch-up amount.

Note: All of these IRAs are intended to be used only during retirement. They therefore have an early withdrawal penalty. Any withdrawal before 59.5 years of age incurs a penalty of 10% plus income taxes (except in a few special rare cases).

So how do you get to millions of dollars?

For most people the only way to really have a chance at getting your IRA to a million dollars or more you need to start early and take advantage of the power of compounding. In essence compound interest is earning interest on your interest.

Compound interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.

The average annual return of the S&P 500 stock market index (since 1957) is approximately 8% Using that rate of return let’s see how the power of compound interest will get you to over a million dollars in your IRA.

With a contribution limit of $6,000 per year lets assume you max out every year and your IRA is invested in a basket of stocks that mirrors the S&P 500 earning an average of 8% compounded monthly (for simplicity sake let’s assume there are no expenses).

If you start early enough so that you have 30 and even 40 years of time to take advantage of compound interest you can easily earn millions of dollars in your IRA. Provided you also have the discipline to max out your contribution every year and not make any early withdrawals.

Keep in mind too that the IRS will certainly be increasing the contribution limit on IRAs in the future just as they have done in the past. This will allow you to earn even more.

Interest rates: Taking a closer look at the table above you will see that increasing the rate of return even slightly will have a dramatic affect on earning millions in your IRA. Just a 2% increase (from 8 to 10 per cent) nearly doubles the amount in your IRA after 40 years. The numbers at even a 12% return are staggering.

Looking beyond the S&P 500 at commercial real estate you can find average annual returns in the USA of 9.5% and residential rental properties have an average return of 10.6% If you do a little digging you can find companies that are offering even more than this.

Conclusion: The key to using your IRA to make millions is to start early and really pursue the highest rate of interest you can find. Being disciplined enough to max out your contribution limit and to never, ever withdraw before retirement. By re-investing all of your earnings you will compound your interest and accelerate your rate of growth. If you are able to take advantage of the much higher contribution limits that are allowed in a SEP or Simple IRA you will make millions even faster (or many more millions over the same period of time).