Opening and contributing to an individual retirement account (IRA) is one of the basic steps in establishing a long-term investment plan. While the exact benefits and features vary depending on income level and other factors, IRAs generally offer a tax-sheltered setting for assets to appreciate.
In order to maximize the value of an IRA, participants are typically encouraged to make the maximum contribution each year. There is, however, another best practice to receive the largest possible advantage from such an account: make the contributions as soon as possible.
Traditional IRA Timing
Individuals under the age of 50 can contribute up to $5,500 each year to a Traditional IRA. This contribution can be made any time between January 1 and April 15 of the following year. (I.e., the deadline for 2015 contributions is April 15, 2016.)
It should not be a surprise to learn that most Americans wait until the last minute. Fidelity reports that almost half of IRA contributions come during the 28 days leading up to the April 15 deadline. If you fall into that category, you should be:
- Proud that you’re taking advantage of one of the most important aspects of financial planning; and
- Embarrassed that you’re leaving a lot of money — potentially tens of thousands of dollars — on the table.
The Cost of Delay
Over the long term, it is generally a best practice to maximize the amount of time assets are housed in tax-advantaged accounts where they have the opportunity to grow. Deadline contributors get a late start, missing out on the potential growth of assets that could occur between the date when contributions are first allowed (i.e., January 1) and when their contribution is actually made (i.e., mid-April for many).
For a single year’s $5,500 contribution, a few months of returns will generally be minimal. Even a 10 percent appreciation would translate into just $550. But when compounded over dozens of years, the difference can become more meaningful. Assuming a 7 percent annual return, a $5,500 contribution made on January 1, 2016 would grow to about $36,570 after 30 years. If that contribution is made the following April, the ending value of the portfolio will be about $3,100 less.
Shows value on January 1, 2045 assuming 7 percent annual return.
When compounded over decades’ worth of contributions, the difference becomes even larger. To illustrate the impact of timing, consider a hypothetical IRA that experiences:
- Annual contribution of $5,500 each year for 30 years; and
- 7 percent annual return on the portfolio.
If the contribution is made each year on January 1, the total value of the account would grow to almost $556,000 over the course of 30 years. If the contribution is consistently made at the April 15 deadline of the following year, that same account would grow to about $510,000 — a difference of more than $45,000.
The chart below shows the ending value of this hypothetical portfolio assuming contributions are made each year on various dates. Each month of delay translates into approximately $3,000 in lost returns at the end of the 30 years:
Assumes 7 percent annual return. For contributions made later than February 1 of the following year, assumes a final $5,500 contribution made on end date. All scenarios assume total contributions of $165,000.
This example assumes that the contribution is made on the same date each year and that no returns are earned in the meantime (i.e., that the $5,500 is available for contribution, but is instead sitting in cash and earning no interest).
The Power of Compounding Returns
The explanation for this huge difference is relatively straightforward. We can start by examining the composition of that $556,000 IRA account at the end of 30 years. The annual contribution adds up to $165,000, but that represents less than one-third of the total value.
Assumes annual contributions of $5,500 and 7 percent annual return over 30 years.
The returns on these contributions equal almost $355,000 — more than the value of the cash contributions made by investors. The gains on this segment of the portfolio — the compounded returns — add another $36,000 over the three decades. In other words, this hypothetical portfolio would leave investors with nearly $400,000 in addition to the contributions they made.
The appeal of maximizing exposure to this type of growth opportunity should be obvious. But many investors delay traditional IRA contributions, likely in part because they underestimate the impact that a seemingly small delay will have on the ultimate value of their portfolio.
Embracing Compounding Returns
Investors face no shortage of obstacles in accumulating wealth, including excessive fees, bad advice, noisy predictions, and occasionally volatile markets. But there are some powerful allies as well, including tax-advantaged accounts and the beauty of compounding returns. In addition to avoiding pitfalls, taking full advantage of the opportunities to accelerate growth is a key to successful long-term investing.
When it comes to making contributions to a traditional IRA, late is certainly better than never. But early is ideal, and is accompanied by a five-figure reward.
This article, The Surprising Truth About Traditional IRA Contributions, first appeared on Dividend Reference.