Individual retirement accounts give you more control over your own financial destiny. Your money grows without incurring current income taxes, whether you make tax-deductible contributions to a traditional IRA or after-tax contributions to a Roth IRA. That means it grows faster than if those investments were in a taxable account. How fast your retirement account grows depends on what investments you buy for your IRA.
An individual retirement account is just that -- an account. Your IRA is not an investment unto itself, but a special type of custodial or trustee account that holds your investments. With very few exceptions, such as life insurance and collectibles, the Internal Revenue Service doesn't limit the types of investments you can buy with your IRA.
Risk vs. Reward
Any investment you hold in your IRA will perform exactly the same way that same investment would perform outside of your IRA. The only difference is the tax consequences. As long as the funds remain in your IRA, they are not subject to current income taxes. Investments in your IRA are subject to the same risks and rewards that would apply outside your IRA. A basic rule of thumb for investing is that greater reward typically involves greater risk. So if you want to increase the growth rate on your IRA investments, you will probably need to assume greater risk. But the converse is not always true: Just because an investment requires greater risk doesn't mean it provides greater potential reward.
When it comes to your retirement money, time is either your greatest ally or your greatest enemy. If you start contributing to an IRA when you are young, the power of compounding can make even small returns produce big results over long periods. If you take big risks and lose, time is still on your side. You have many years in which to make up for your losses. When you're older, time starts to work against you. As you approach retirement age you don't have the luxury of guessing wrong on a risky investment, because you won't have time to make up for the loss if the investment goes south.
The U.S. Securities and Exchange Commission recommends diversifying your investment portfolio among asset categories, and within asset categories. For example, you might use your IRA contributions to buy stocks and bonds. To be properly diversified, you would need stocks of companies in different industries and economic sectors. You might hold both U.S. government bonds as well as corporate bonds and bank certificates of deposit. Diversification is primarily a protective investment strategy. When you don't have all your eggs in one basket, if one investment takes a major hit the other investments in your IRA can reduce your total portfolio's overall loss.
The mix of investments in your IRA is likely to change as you approach retirement age. How you decide to allocate the assets in your IRA depends on your investment goals and temperament. The more aggressive you are with your investments, the higher your potential reward, but your potential loss is also increased. You can expect an aggressive investment portfolio to return approximately 7.2 percent per year over 10 years, according to the American Association of Individual investors. A moderate portfolio should grow at 6.6 percent during that same time frame, while a conservative portfolio should provide an annualized return of 5.9 percent.
- Scottrade: Calculators, Traditional IRA vs. Roth IRA
- Internal Revenue Service: Topic 451 -- Individual Retirement Arrangements (IRAs)
- Securities and Exchange Commission: Beginners' Guide to Asset Allocation, Diversification, and Rebalancing
- American Association of Individual Investors: AAII Asset Allocation Models
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.