How Does a Roth IRA Compound Interest?
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Get a Roth IRA
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A Roth IRA is a simple investment account that is designated as a retirement account by the government. You can get one through any financial institution. Set up the account and deposit money in it, and invest in stocks, money markets or CDs. You do not take a tax break on the money put into the account. The tax break comes later. When you withdraw the money, you owe no capital gains taxes on the interest you gained. That means you could save a lot of money, if you earn a great deal of interest on these funds, and are in a higher tax bracket when you retire. You will enjoy a larger return because you aren't paying any taxes.
Tax Free Growth
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Interest accrues on an IRA tax free, which means you do not have to pay capital gains tax on the interest when you withdraw it at the age of 59 1/2 or older. On all other accounts, including a regular IRA, you must pay a tax on the capital gains you made. Capital gains are any gains over the initial principal you invested. If you put $1,000 into the account, and earned $500, you would pay a percentage of the $500 in a normal account. In a Roth IRA you would receive the entire $500.
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Compound Interest
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Interest compounds in a Roth IRA. That means the interest is added to the principal every day and then the new amount of interest is calculated on the new principal the following day (interest rate x principal + yesterday's interest, then repeat again the next day). If your IRA compounds daily, and you earn $1 the first day, the next day you will earn interest on $1001 instead of on $1,000. That means more interest the next day. Accounts can compound daily, weekly, monthly or yearly.
Tax Free Compound Interest is a Powerful Tool
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You earn more interest on a larger sum of money--it is a mathematical fact. So, if you earn interest tax-free every year, your account grows faster, because you aren't depleting it with tax payments every year. So more interest is paid on a higher balance. Compound interest also increases your balance faster, because it is paid daily, and after each payment, the amount of interest you earn also goes up.
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