Whether you have savings in your individual retirement account, in a Roth IRA or you hold it as a part of your taxable investments, the interest rate calculation is the same. The key difference is how much of your interest you get to keep working for you. Until you make a withdrawal in retirement, none of your interest goes to pay taxes with an IRA, meaning that you have more money to compound for you.
Savings accounts certificates of deposit are both essentially loans that you make to your bank. When you deposit money at your bank, you give the bank license to use the money as it sees fit. Just like when you borrow money and pay interest, the bank pays you interest on the money it borrows from you. With a savings account, you can call the loan at any time by withdrawing your money, so the bank typically pays you a low rate. CDs accounts, though, are more stable for the bank, since you agree to let the bank have your money for a set period of time, so it usually will pay you a higher rate.
Interest, APY and Compounding
Banks usually quote interest rates annually. A $95,000 account with a 1 percent interest rate should receive $950 in interest per year. However, most banks compound the interest throughout the year, with daily compounding being common. Daily compounding means that the bank pays you a little bit of interest every day, adds it to your balance and pays the next day's interest on the higher balance. For instance, if you have a 1 percent rate, you actually get 0.00274 percent interest per day. At the end of the day on Jan. 1 your $95,000 balance turns into $95,002.60, and at the end of the day on January 2, you have $95,005.21. This continues throughout the year, and you end up with roughly $95,954.75, instead of the $95,950 that you'd get with simple interest. The higher yield that you get through compounding is sometimes expressed as an annual percentage yield. The APY of a 1 percent account with daily compounding is approximately 1.005 percent.
Where the IRA comes into in play is in the fact that it keeps your interest working for you. If you earned $954.75 in a taxable account and had to pay 25 percent tax on it, you'd only have $716.06 left. In year two, the IRA account goes from $95,954.75 to $96,919.10, while your taxable account goes from $95,716.06 to $96,678.01, but after $240.49 in taxes, you only have $96,437.52 left. After 20 years, the IRA has $116,032.88 while the taxable one has just $110,394.64. After paying 25 percent tax on your IRA's $21,032.90 earnings in one lump sum, you'd have $110,774.68 left.
Impact of Higher Interest
At low interest rates, compounding and the impact of tax savings aren't that big. A small improvement on a small amount doesn't matter much. However, the numbers work differently on accounts with a higher rate of return. From 1993 through 2012, the average annual interest on a five-year CD was 5.116 percent, which works out to roughly 0.014 percent interest per day. $95,000 invested for 20 years at that interest rate in a taxable account turns into $205,631.96. In an IRA, it turns into $264,278.95 and, after paying $42,319.74 in taxes, you'd still have $221,959.22 left. The daily compounding makes a difference, too. In year one, you earn $4,986.31 in interest compounded, but a straight 5.116 percent interest rate non-compounded would work out to just $4,860.20.
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