I won’t keep you in suspense: You’ll be able to contribute $500 more to an Individual Retirement Account (IRA) next year. The 9% increase to $6,000 in 2019 — from $5,500 in 2018 — is the first raise to the contribution limit since 2013.
And more important, the increase could boost your retirement savings by tens of thousands of dollars because of compounding. Read on to learn how contributing this extra $500 every year may help you reach your retirement savings goal faster.
What’s an IRA again?
A staple of retirement savings for many, IRAs allow people to make tax-advantaged contributions so they can accumulate savings. You can contribute to a traditional IRA and get tax savings up front, or you can contribute to a Roth IRA and get tax savings in retirement.
With a traditional IRA, you can claim a tax deduction up to the amount you contribute in the year you make the contribution, if you qualify.
Specifically, if you file your taxes as married filing jointly and you’re covered by a retirement plan at work, then you’ll only qualify for the full tax deduction if your joint adjusted gross income is less than $103,000 in 2019. If you’re not covered by a plan at work but your spouse is, then the income limit for the full deduction is $193,000 next year. The limit for singles is lower. Single people covered by a plan at work can take the full deduction for their contribution only if their adjusted income is below $64,000 in 2019.
With a Roth IRA, you can’t take a tax deduction in the year you contribute, but contributions will grow tax free if the account is open at least 5 years and you don’t withdraw any money until you’re at least 59 1/2 years old. To contribute the full $6,000 possible to a Roth IRA in 2019, your adjusted gross income must be below $122,000 if you’re single or $193,000 if you’re married filing jointly.
This increase can add up over time
Although the increase is only $500 per year, contributing the maximum $6,000 to an IRA every year could yield a lot of extra money in retirement.
For example, let’s say Jeff is 45 years old and he has $100,000 in retirement savings already. Under the previous $5,500 IRA contribution limit, he could end up with $987,762.26 at age 65 if he contributed the maximum amount annually and earned a 10% return per year (the stock market’s return has historically been about 10% annually).
Following the increase in the IRA limit, Jeff’s account could be worth $1,016,399.99 if he contributed the maximum $6,000 each year and earned a 10% annual return. Therefore, the $500 increase to the IRA limit results in an extra $28,637.73 in retirement savings despite the fact he only contributed an additional $10,000 over the period ($500 annually for 20 years).
The impact of the new IRA contribution limit is even bigger for someone who is younger.
Let’s say Kim is 35 and, like Jeff, she has $100,000 put away in her IRA so far. The additional 10 years of contributing $6,000 per year until age 65 results in a portfolio worth $2,731,904.36. Under the $5,500 contribution limit, Kim would have only ended up with $2,649,656.69. Therefore, contributing that additional $15,000 over the 30-year period ($500 annually for 30 years) resulted in an additional $82,247.67 in her account.
Here’s what’s behind this magic
A small $500 more per year in contributions results in so much more money over time because of compounding.
Simply put, compound interest is the ability to earn interest on interest, and compound growth is the ability to earn returns on your returns.
For instance, let’s assume you have $100 and you’re going to earn 10% per year in compound interest for five years. After the first year, you would have $110.
After year two, you’d have $110 plus $11 in interest for $121. And in year three, you’d earn 10% of $121 ($12.10) for a total of $133.10.
Over the five-year period, your $100 investment would grow to $161.05 because of compound interest (but since stocks don’t produce a fixed 10% annual return, these results even out over the long term).
The potential for compounding to add so much more to retirement accounts makes contributing the extra $500 to your IRA next year compelling.
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