How Does an IRA Grow?

Contributions

The most obvious source of growth in your IRA is your contributions. Individuals are allowed to contribute up to $5,000 a year to an IRA, and that limit gets higher every year. Keeping up your contributions is a great way to make sure that your IRA grows in value. Even if you don't earn any interest at all on the money, after 30 years, you'll have $150,000 if you invest $5,000 each year.

Investments--CDs and Money Market Funds

The types of investments you choose for your IRA will determine the rest of its growth. If you choose to invest your IRA money in CDs or money market funds, you will simply earn interest on the money, just as you would in a regular savings account. There will be little or no risk of losing money, but the amount of interest you can earn in "safe" vehicles like CDs is usually not enough to even keep pace with inflation. About 4 to 5 percent a year is likely the most growth you can hope for with CDs. At 5 percent interest, $5,000 invested today will only be worth about $21,600 in 30 years. If you invest $5,000 a year for 30 years at 5 percent interest, you'd have about $350,000--unfortunately, that $350,000 would only be worth about $140,000 in today's dollars if inflation stays around 3 percent.

Investments--Bonds or Fixed Income

Bonds are a popular investment for older or risk-averse investors because of their reputation as being "safer" than stocks. Bonds do tend to be less volatile than stocks, but their average returns are less than that of the stock market as well. Most financial experts believe that bond investments will grow an average of 6 to 8 percent over time, but that figure could be much higher or lower in the short term. Nevertheless, bonds are an excellent way to help stabilize an investment portfolio, since they are much less volatile than stocks. Bonds help grow your IRA by paying dividends, which can then be reinvested or spent. If you invested $5,000 a year for 30 years at 7 percent interest, you'd end up around $500,000--not too bad.

Investments--Stocks and Mutual Funds

For the majority of investors, stocks (or stock mutual funds) will be the best way to grow an IRA. Stocks are quite volatile, and there is certainly a chance that stocks will lose value, especially in the short term. However, since IRAs generally have a long term investment horizon, stocks are the best way to get returns that will not only beat inflation, but allow your money to compound. Stocks grow your IRA in two ways--through dividends and increases in share price. Investors hope that the stocks they buy today for $20 will be worth for $40 (or more) when they choose to sell them. Those profits can then be reinvested or spent. Also, certain stocks pay dividends as well, which can also be used to grow your portfolio. It is extremely difficult to say how much growth an investor can expect from a stock portfolio, but financial experts say the range can be anywhere from 8 to 12 percent long term. If you invest $5,000 a year for 30 years and get a 10 percent average return, that's $900,000. Given the greater growth potential of stocks, it's no wonder they're one of the most popular choices for IRA investments.

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