Saving on taxes is often a priority for workers as they plan for retirement.
A Roth IRA is a tax-advantaged retirement account that can lower your post-work tax burden by allowing your contributions to grow tax-free. This is because Roth IRAs are funded with after-tax dollars, so account owners pay no taxes on withdrawals during retirement or after age 59 1/2.
While its tax benefits are clear, estimating how much of a return you can expect from a Roth IRA is less straightforward. Here’s what to consider as you set up your Roth IRA.
[Related:7 Things to Know About Withdrawing Money From a Traditional IRA]
Historical Average Returns of Roth IRAs
When estimating returns from a Roth IRA, it’s important to understand that the Roth is simply a type of qualified account. The account owner chooses the investments, which determine the return.
For example, a Roth IRA consisting of 60% stocks and 40% bonds is likely to return more than a Roth consisting of 40% stocks and 60% bonds. That’s because stocks are riskier assets than bonds and generate a higher return.
“The Roth IRA is merely a shell designed to hold investments and provide tax advantages to the investments held within it,” said Kevin Ross, financial advisor at Cardea Capital Advisors in Bala Cynwyd, Pennsylvania, in an email.
“The Roth IRA has no effect whatsoever on investment returns, only on how those returns are taxed,” he added.
To estimate the average return for Roth IRAs, Ross said, investors need to look at the underlying investments most commonly held in this type of account.
[READ: IRA Versus 401(k): Which Is Better?]
What’s Held in a Roth IRA?
Investors should keep in mind that a Roth IRA isn’t a product in the way that a mutual fund or annuity is, but is a type of investment account. Investors can hold a range of assets inside a Roth IRA, including stocks, bonds, mutual funds and exchange-traded funds, and get the benefit of tax-free withdrawals. While it’s possible to hold cash equivalents such as money market funds in a Roth, that would severely limit the potential upside.
“A person could use growth mutual funds, a product, inside their Roth IRA,” said Bob Chitrathorn, vice president of wealth planning at Simplified Wealth Management in Corona, California, in an email. “If said growth fund has averaged 8% a year for 10 years, their Roth IRA would have the same return,” he added.
Comparing Roth IRA Returns to Other Retirement Accounts
Determining the return of a broad account category such as a Roth IRA is difficult because the underlying investments will vary. Historically, the average annual return for a Roth IRA or any other type of account invested heavily in stocks can range from 7% to 10%.
That estimated return assumes a diversified portfolio over a long-term investment horizon, similar to the stock market’s historical performance. However, individual returns depend on market conditions, the specific assets chosen for the Roth and the percentage allocated to each asset.
For example, a portfolio that tilts toward bonds will return less but it is also less risky. That decreased risk level is why many investors in or near retirement shift a higher allocation into fixed income.
Tax Benefits Can Boost Long-Term Growth
While the underlying holdings play a role in determining a Roth IRA’s return, investors should also consider the account’s tax advantages when estimating their potential return.
“Compared to other retirement accounts such as traditional IRAs or 401(k)s, Roth IRAs tend to have higher potential for long-term growth due to their tax-free withdrawals in retirement,” said Michael Collins, a chartered financial analyst and CEO of Wincap Financial in Winchester, Massachusetts, in an email.
Because Roth IRA earnings are not taxed upon withdrawal, he added, a Roth is an attractive option for people expecting to be in a higher tax bracket during retirement.
[READ: How Roth IRA Taxes Work]
Strategies to Maximize Roth IRA Returns
When it comes to maximizing returns in a Roth IRA, there aren’t any hacks or tricks. Instead, it’s a matter of contributing regularly and investing thoughtfully.
Strategies to maximize Roth IRA returns include choosing a diverse range of investment options with different levels of risk and potential for growth, Collins said. Make consistent contributions over time rather than lump-sum payments, and take advantage of catch-up contributions if you’re eligible. Make a habit of regularly reviewing your portfolio and rebalancing it as needed.
“It’s also important to regularly monitor fees associated with managing your account and make adjustments if necessary,” he added.
Time Horizon Can Impact Roth IRA Returns
The longer the time horizon, the more predictable the stock market’s returns become, Ross said.
Because Roth IRAs can’t be accessed without a penalty before the account owner turns 59 1/2, these vehicles offer a longer time horizon. “The key is to embed investments into your Roth IRA that are reflective of your time horizon and risk tolerance,” Ross said. “Those with a long time horizon should have a higher tolerance for risk than those that don’t.”
“Investors with a shorter time horizon typically must invest more conservatively, which tends to equate to lower returns over time,” he added.
Leaning more heavily on stocks, for example, is appropriate for a Roth IRA that has years to grow and more time to absorb risk. Leaning too heavily on bonds means missing opportunities for growth.
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What Is an Average Roth IRA Return? originally appeared on usnews.com
