This One Thing Will Get You to $1 Million (Tax-Free!)

by Keith Whelan on 14 July 2014 2 comments

We're surrounded by financial advice, often in the form of lists containing 10 (or 25! or 50!) things you can do to help solve a particular problem. While much of this information is useful, it can also be overwhelming. Where do you begin? On what things should you focus your efforts?

I'd suggest starting with the end in mind — with your ultimate goal — and let that guide you to the highest priority activities to help you achieve it. For most of us the end goal is financial independence, and that requires accumulating enough wealth to no longer rely on income from a job. (See also: How Cash Flow Allocation Helps You Retire)

Okay, here's where focusing on the highest impact activities comes in. For most Americans, only two financial items generate around 80% of their wealth: real estate and retirement savings. Let's tackle one of them, retirement savings. If you get that one thing right then hundreds of other, lower impact activities won't matter much.

Retirement Savings

So let's begin. What are some typical sources of retirement savings?

  • Your employer (in the form of a 401(k), 403(b) or similar program, or in rare instances a pension).
     
  • The government (Social Security retirement payments).
     
  • Yourself.

Unfortunately, the first two sources are becoming increasingly uncertain, so let's narrow our focus even further, on the one retirement savings source where you have complete control: Yourself.

IMPORTANT! Before proceeding, I would strongly suggest that if your employer offers a matching 401(k) or similar program that you contribute an amount that gets you the maximum match. What we're addressing in this article will supplement that 401(k) savings plan, if you're lucky enough to have one.

Alright, so what one thing that you have control over can get you to $1 million in retirement savings, tax free? Drum roll, please….

It's a Roth IRA

Contribute $200 per month into a Roth IRA (where earnings on the account and withdrawals after age 59½ are tax-free).

That's it! Simple, isn't it?

Actually, yes, it is simple. That's the beauty of it. But it does require meeting a few conditions.

1. Invest the Money in Stocks

You have the option of putting your Roth IRA contributions to work in one or a combination of investments such as bonds, treasuries, CDs, money market funds, and stocks. Unlike bonds, treasuries, and especially CDs or money market funds, stock market returns have historically outpaced inflation by a comfortable margin. Over the past 50 years stock funds invested in large companies have yielded a return of 9.2%. Over the past 20 years it's been 7.9%. For our purposes, to be conservative I will assume an average return of 7.5%.

2. Stick With It!

Religiously. Even obsessively, if that's what it takes. Make that $200 contribution without exception every month until it becomes automatic. In fact, setting it up as an automatic transfer from each paycheck is the best way to go. That way you never see the money and therefore never miss it.

3. Wait

This is where the magic occurs. After contributing long enough you'll reach a threshold, where your total saved amount starts to achieve a dramatic upward trajectory due to compounding.

The Power of Compounding

To illustrate the magical power of compounding, consider the story of the king and the court jester. Legend has it that a long, long time ago a court jester's heroic act saved his king. The king was so moved by the jester's bravery that he offered to give the jester anything he wanted. The jester asked for one cent, doubled each day for a month. "That's all?" said the king. The wish was granted. (See also: 10 Easy Ways to Supercharge Your Retirement)

Halfway through the month the balance grew to only $164. But during the final week it started its rapid rise — it passed the threshold — and spiked upwards, ending the month at over $5.3 million.

As you can see in graph, it took some time for the small initial amount to grow. Eventually, though, the balance grew large enough so that with each doubling it started shooting up very rapidly. That's the threshold you want to reach. But to do so you need to start early — i.e. NOW!

How Long Will It Take?

So, how long are we talking about to reach this magic threshold? If you start at age 21 and your $200 monthly Roth IRA contributions grow at 7.5%, then you will reach $1 million, tax-free, at age 67, which is the current target age for receiving full Social Security retirement benefits if you were born after 1960.

What if you were to start saving at age 31 instead of 21? Then your total will only be $360,000. Big difference. That's because you didn't quite reach the threshold where compounding really starts to kick in. But still not bad.

Now I'm guessing that not everyone who reads this is 21 years old, so you're probably thinking "What can I do to make up for lost time?" Here are some ideas:

  • At $200 per month your total annual contribution will be $2,400 but for most households the maximum annual Roth contribution is $5,500, so if you can afford it double your monthly contribution until you're caught up.
     
  • If you have money in a savings account, consider transferring up to $3,100 from it to supplement your $2,400 annual amount.
     
  • You can reach your annual contribution limit by transferring money from a tax-deductible account (such as a traditional IRA) to a Roth in the same year. (Check with a financial or tax professional to be sure you understand the rules for this kind of transfer.)
     
  • Getting a tax refund? Put all or a portion of it into the Roth account.
     
  • Take advantage of the Roth IRA "float" period, which allows you to count contributions made until April 15th towards the previous year's total.
     
  • Over time, as your earnings grow and you can afford more than $200 per month, increase that monthly contribution by $50 or $100 or more. Consider having all or part of your annual raise in salary automatically added to your monthly Roth contribution.

At a time when a slew of financial information and advice seems to be coming at us from all directions it's easy to feel overwhelmed. You don't need to be. Take back control by keeping things simple and focusing on this one activity. As you approach your golden years and reach the threshold, you'll be glad you did.

Have you taken this one simple step toward putting aside money for retirement?

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I don't know any 21 year old who is able to save $200 per month.

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Josh

In all honesty, a Roth IRA is not fully tax free. You fund it with after-tax money. To be totally tax free, it would have to be funded with before-tax money, have tax-free growth, and have tax-free distributions (much like a health savings account!).