How much does maxing out your IRA go towards your retirement?

I just received an email from my discount brokerage firm. Most of the emails I receive from these financial houses are oriented towards mutual funds and IRAs, because, of course, that is what they sell. It’s only natural. The only other emails I get is when I perform some transaction.

Today I got one that read “Even if you are only 10-15 years from retirement, you can still save a substantial amount in an IRA.” Is that true? What would the evidence suggest?

Looking at the table they included (as well as checking the IRS web site), contribution limits for 2013 are $6500. It’s possible to save up to your total earned income, but it’s capped at $6500, so let’s assume we manage to do that. Let’s also assume we get that maximum window they are telling us of 15 years. What is $6500 x 15 years? $97,500

But don’t forget, the increase the contribution limit each year to compensate for increased cost of living. They increased it by $500 from 2012, so let’s assume they will do that every year. Using a spreadsheet, you will find that saving $6500, then $7000, etc. for 15 years creates $150,000.

First of all, how useful would $150,000 be if we were just entering retirement? At first blink, that sounds nice. But when talking about retirement planning, which hopefully would last at least 20 years if not more, it just’s not that much. If you factor in a 4% inflation, in 15 years, that chunk of money would be equivalent to $83,000 plus a latte in today’s dollars. Yikes! That kind of sinks the party.

Next, let’s think about the magic of compound interest. Everyone likes to mention that in financial articles, because it’s the most powerful tool every invented! Whether or not Einstein actually referred to compound interest as the most powerful force every created, financial advisors like to make you comfortable in your progress to retirement by making it sound as if it will always be there to catch you up at the right time.

In the article I saw they said that “you’ll benefit from time and the power of compounding to significantly grow your retirement savings.” That is a killer soundbite. Except your performance according the financial laws of compound interest can swing wildly either in your favor or against your favor.

If you restrict yourself to only investing in mutual funds and index funds, then you’ll have to be happy with averaging around 4% in annualized growth according to the Dalbar report, which won’t cut it. I took the liberty of punching the numbers up above into my spreadsheet, multiplying the total cash saved each year by a fluctuating growth rate of mostly positive growth with only one loss in that entire 15 year stretch. Considering we have historically suffered a market correction about every ten years, this should prove somewhat conservative.

You know what I got? A total cash value of $210,000. That may sound better, but it’s not a huge return after investing $150,000. In fact, that it’s only a measly 2.2% annualized growth rate!

Click on the image to zoom

You could potentially do better than the mutual funds if you invested that money into some dividend kings and reached retirement with a nice 4% yield in stocks. But don’t fool yourself into thinking this is all you need to do to retire. That kind of yield would only produce $8400 annually, averaging $700/month.

I don’t think $700/month, or $388/month in today’s dollars, counts for “significant” in retirement savings as that article implies. When these articles wave the magic wand of “compound interest” and “dollar cost averaging,” watch out. They are attempting to cast a spell on you to make you think this can grow HUGE.

Dividend kings may help you grow the net worth of your equities better than mutual funds, but make no mistake. Limiting yourself to setting aside $6500 in an IRA just won’t cut it. For example, if life interrupts and causes you to miss any of these contributions, your end results will only diminish. This is the best, and it doesn’t and consider what happens during the worse, such as a market correction the year before you retire or two corrections in the same span of time.

If you already have something else that will provide your main source of income in retirement, then I wouldn’t object to having this IRA to use as fun money. But consider this: is your other source of retirement an order of magnitude bigger in the amount of money being saved, or is it similar to this? If it’s relatively the same in total dollars saved every year, the best you can is double the outcome. Is that really going to be enough?

By all means, I encourage you to create your own version of the spreadsheet up above. Don’t like the rates I picked? Punch in your own percent growths. Try the last 15 years in average S&P 500 performance and see what you get. You may find that things don’t quite work out as well as you heard about in articles and on the radio. And feel free to contact me if you have any questions.

Leave a Reply

Your email address will not be published. Required fields are marked *