Do IRAs Earn Interest? The Truth About How Your Retirement Account Actually Grows

The Big Misconception About IRA “Interest Rates”

If you’ve been looking for the best IRA interest rates, I have bad news: you’re not looking for them! This is one of the most common misconceptions about Individual Retirement Accounts (IRAs), and I wish someone had told me this years ago.

Here’s the simple truth: IRAs don’t earn interest on their own. They aren’t like savings accounts or CDs with fixed interest rates. Instead, an IRA is more like a special container that holds different types of investments – and those investments are what actually generate returns.

Think of an IRA like an empty basket. The basket itself doesn’t produce anything but what you decide to put inside that basket can grow over time. That growth comes from the performance of whatever investments you choose not from a preset “IRA interest rate.”

How IRAs Actually Grow Your Money

So if IRAs don’t pay interest themselves how do they help you build retirement wealth? Let’s break it down

1. Investment Returns, Not Interest

The growth of your IRA depends on how well the investments you choose to keep in the account do. These returns typically come in three main forms:

• Capital appreciation: When your investments increase in value (like stocks going up in price)
• Dividends: Payments companies make to shareholders from their profits
• Interest: From bonds, CDs, or other fixed-income investments you hold within the IRA

2. Compounding: The Real Magic

One of the most powerful aspects of an IRA is the effect of compounding. This happens when your investment earnings generate their own earnings over time.

For example, Investopedia notes that investing $6,500 annually for 30 years with a 5% return could grow to over $450,000, despite only contributing $195,000 personally. Even more impressively, with a 10% average return (which some stock index funds have historically achieved), that same contribution pattern could potentially grow to over $1 million!

3. Tax Advantages

IRAs offer significant tax benefits that can dramatically boost your overall returns:

• Traditional IRA: Contributions are typically tax-deductible, and growth is tax-deferred (you pay taxes when you withdraw)
• Roth IRA: Contributions are made with after-tax dollars, but all growth and withdrawals in retirement are completely tax-free

Because of these tax breaks, your money can grow faster than in a regular taxable account, where you’d have to pay taxes every year on investment gains.

Common Investments Inside IRAs

What you put in your IRA has a huge impact on your returns. Here are some popular options:

Stocks

Individual company shares offer the highest growth potential but also come with more volatility. Historically, the stock market has returned about 10% annually before inflation (around 6-7% after inflation), making stocks a popular choice for long-term IRA growth.

Bonds

Government or corporate bonds pay regular interest and are generally less volatile than stocks. They typically offer lower returns but provide more stability and income.

Mutual Funds & ETFs

These pooled investments let you own a diversified portfolio of stocks, bonds, or both. They’re popular in IRAs because they provide instant diversification and professional management.

Index Funds

These funds track specific market indexes (like the S&P 500) and typically have lower fees than actively managed funds. They’re a popular “set-it-and-forget-it” option for IRA investors.

Cash and CDs

Some IRAs include cash components or Certificates of Deposit, which do earn traditional interest but typically at much lower rates than what stocks or bonds might return over the long term.

Roth vs Traditional: Which Grows Better?

A common question I get is whether Roth or Traditional IRAs grow differently. The contribution limits are identical – $7,000 in 2024 ($8,000 if you’re 50+) – and both accounts can hold the same types of investments.

The main difference isn’t in how they grow, but in when you pay taxes:

Traditional IRA:

• Funded with pre-tax dollars (contributions may be tax-deductible)
• Pay taxes on both contributions and earnings when you withdraw in retirement
• Must take Required Minimum Distributions (RMDs) starting at age 73 (or 75 if born in 1960 or later)

Roth IRA:

• Funded with after-tax dollars (no immediate tax break)
• All qualified withdrawals are completely tax-free in retirement
• No RMDs during your lifetime

For many people, a Roth IRA provides better long-term growth potential because you don’t lose any of your earnings to taxes when you withdraw. This is especially valuable if your investments perform exceptionally well.

Factors That Affect Your IRA’s Growth

Several key factors determine how quickly your IRA will grow:

1. Your Investment Choices

The specific investments you select have the biggest impact on your returns. Higher-risk investments like stocks typically offer higher potential returns but with greater volatility.

2. Consistent Contributions

Making regular, ideally maximum, contributions dramatically affects your account growth over time. Even missing a few years of contributions can significantly reduce your final balance.

3. Time Horizon

The longer your money can stay invested, the more it benefits from compounding. Starting early gives your investments more time to grow and recover from market downturns.

4. Fees and Expenses

Investment fees can seriously eat into your returns over time. Look for low-cost investment options and IRA providers with minimal fees.

Where to Open an IRA for Best Growth Potential

The financial institution where you open your IRA affects your investment options and costs. Here are some popular options:

Brokerages

Companies like Charles Schwab, Interactive Brokers, and Robinhood offer the widest range of investment options, including individual stocks, bonds, and thousands of funds.

Robo-Advisors

Services like Wealthfront and Betterment build and manage a diversified portfolio for you based on your goals and risk tolerance, typically using low-cost ETFs.

Banks

While convenient, bank IRAs often limit you to their own CDs and savings products, which typically offer much lower growth potential than stock-based investments.

A Real-World Example of IRA Growth

Let me share a realistic example of how an IRA might grow over time:

Sarah opens a Roth IRA at age 30 and contributes $6,000 annually. She invests primarily in a diversified portfolio of index funds that historically return about 7% annually after inflation.

By age 65, her account would grow to approximately $825,000, despite only contributing $210,000 personally. The remaining $615,000 came from investment growth – not from “interest” on the IRA itself, but from the performance of the investments she chose within the account.

Why Your IRA Might Not Be Growing

If your IRA isn’t growing as expected, here are some possible reasons:

• Poor investment choices: Your selected investments may be underperforming
• High fees: Excessive management or trading fees can reduce returns
• Market downturns: Even well-diversified portfolios experience temporary declines
• Insufficient contributions: You may not be contributing enough to see significant growth
• Too conservative: If your investments are too heavily weighted toward cash or low-yield options, growth will be limited

FAQ: Common Questions About IRA Growth

Can I lose money in an IRA?

Yes! Unlike bank accounts, IRAs that contain market-based investments can lose value if those investments decline. Your principal is not guaranteed unless you choose guaranteed investments like CDs within the IRA.

What’s the average return for an IRA?

There’s no such thing as an “average IRA return” because IRAs can hold virtually any type of investment. Historically, diversified stock portfolios have returned about 6-7% annually after inflation, while bonds have returned about 3-4%.

Should I max out my IRA contributions?

If possible, yes! The annual contribution limits ($7,000 in 2024, or $8,000 if you’re 50+) are relatively modest compared to the tax benefits you receive. Maximizing contributions is one of the most effective ways to build retirement wealth.

Can I have both a Roth and Traditional IRA?

Yes! You can contribute to both types, but your total combined contributions can’t exceed the annual limit. This strategy lets you diversify your tax treatment.

Final Thoughts: Focus on Investments, Not “Interest”

The biggest takeaway here is that when it comes to IRAs, we should stop thinking about “interest rates” and start focusing on investment selection and strategy. Your IRA’s growth potential isn’t limited by fixed interest rates – it’s determined by the specific investments you choose to hold within the account.

By understanding that IRAs are investment vehicles rather than interest-bearing accounts, you can make better decisions about where to open your account, what to invest in, and how to maximize your long-term returns.

Remember: the IRA itself is just the tax-advantaged container. The real growth happens because of what you put inside it and how long you let it grow.

So next time someone asks you about “IRA interest rates,” you can set them straight – and potentially help them make much better retirement planning decisions!