Determining Rates of Return
When you open a Roth IRA account, you choose your investments. The rates of return on a Roth IRA depend on the performance of the investments you choose and are not guaranteed. Historical returns on stock and bond indices can help you estimate future returns.
Calculating the Expected Rate of Return
There are no guarantees for Roth IRA returns, but by looking at historical returns for each asset class and comparing them to your asset allocation, you can calculate the expected rate of return.
Stocks
Stocks are the riskiest asset class, but they produce the highest rate of return. One widely used benchmark for domestic stock performance is the Standard & Poor’s (S&P) 500, which represents over 80% of the value of the U.S. stock market. Over the past 50 years, the S&P 500 has achieved an average annual return of about 10%, assuming dividends are reinvested.
Bonds
The Standard & Poor’s U.S. Aggregate Bond Index is a common measure of the bond market, tracking the performance of investment-grade debt in the United States. The average annual return for the index over the past decade has been around 1.6%, as of April 29, 2022.
Cash
Cash and cash-equivalent assets such as certificates of deposit and money market accounts are the most predictable asset classes. They are insured by the Federal Deposit Insurance Corporation (FDIC), so even if your financial institution fails, you will receive your principal plus interest on deposits up to at least $250,000.
Calculating Rates of Return for Hypothetical Roth IRA Accounts
Let’s calculate the rate of return for two hypothetical Roth IRA accounts over a decade. We will assume annual returns of 10% for stocks, 2% for bonds, and 1% for cash, using a compound interest calculator to make forecasts. For simplicity, we will assume you have $100,000 invested and make no additional deposits.
85% Stocks, 10% Bonds, 5% Cash
If you are a relatively active investor, you might allocate 85% of your assets to stocks, 10% to bonds, and 5% to cash-equivalent assets.
Initial value of assets: $85,000 in stocks, $10,000 in bonds, $5,000 in cash.
Final value after 10 years: $238,180.
40% Stocks, 40% Bonds, 20% Cash
Now let’s assume you are a conservative investor allocating 40% to stocks, 40% to bonds, and the remaining 20% to cash-equivalent assets.
Initial value of assets: $40,000 in stocks, $40,000 in bonds, $20,000 in cash.
Final value after 10 years: $174,600.
Additional Considerations
There are other factors to consider when looking at a Roth IRA return or any investment account, not just how much it earns, but how much of those earnings the investor receives during the accumulation phase over time and how much is retained after taxes.
Assuming there are three different investment accounts, all invested in the same assets, you could see very different outcomes.
An account that is not a retirement account will be funded with money that has already been taxed (therefore having less money to invest initially), and then might be subject to taxes each year (leaving less to accumulate annually). Over a long investment horizon, that money will grow less.
A traditional IRA account is funded with pre-tax income (so there is more money available to invest initially), and then remains tax-deferred while it grows over time, allowing for tax-deferred accumulation. You still have to pay income taxes on your withdrawals at retirement, but that money will grow more over a long period because the money that would have been lost annually due to taxes is also working every year.
The initial contributions to a Roth IRA have already been taxed, but they benefit from tax-free accumulation over the years. Then, unlike a traditional IRA, withdrawals made at retirement are often not taxable, meaning you will have more gains upon retirement.
This
The three different accounts, when investing in the same assets, will leave the investor with completely different after-tax returns at retirement.
What is the ideal rate of return for a Roth IRA account?
The ideal rate of return for a Roth IRA account is about 10%, which is the average annual rate for the S&P 500 index. However, as you approach retirement, the ideal rate of return may be lower than 10%, as you might want to rebalance your asset allocation to have a greater concentration of safe assets such as bonds and cash-equivalent assets.
When can I withdraw from a Roth IRA account?
You can withdraw your contributions from a Roth IRA account at any time without paying taxes or penalties. To avoid paying income taxes or a 10% early withdrawal fee, wait until you are 59 and a half years old and have had the account for at least five years to withdraw investment earnings.
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Source: https://www.thebalancemoney.com/how-to-calculate-the-expected-rate-of-return-on-a-roth-ira-5270720
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