One of our favorite articles from Vanguard explains why contributing to your IRA (sooner rather than later each year) adds up to more money when you retire.
You can make an IRA contribution for a given year anytime between January 1 and the tax-filing deadline of the following year (usually April 15). For the 2020 tax year, the IRS has extended the deadline to May 17. So now you can make a 2020 IRA contribution between January 1, 2020, and May 17, 2021—but Vanguard doesn't recommend waiting. Here’s why.
The point of investing
You invest to earn money. The amount of money you earn depends primarily on 3 factors—2 of which you can control.
- Investment performance. You can’t control investment performance; that’s why all investing involves risk. The main cause of risk? Market movement, which affects your investment earnings (i.e., your total return).
- The amount you invest. You earn money through compounding—when your investment earnings generate their own earnings. If you contribute more, you have more money to generate earnings … which means you have more earnings to generate additional earnings. You can control the amount you invest as long as you stay within the annual IRA contribution limit.
- When you invest. If you wait until the deadline to make an IRA contribution, you’ve missed close to 16 months of compounding. If you have the financial flexibility to choose when you contribute to your IRA, do it as soon as possible. Learn how time is related to risk and reward.
Time is money
Let’s say you invest $5,500 in your IRA every year for 30 years and your average annual return is 4%.**
- Example A: You make a lump-sum investment every January and your end balance is $323,967, which includes $158,967 in earnings.
- Example B: You make a lump-sum investment every April and your end balance is $308,467, which includes $143,467 in earnings. That’s $15,500 less than you’d earn in Example A.
In each example, you’re contributing a total of $165,000 to your IRA over the course of 30 years. The difference in earnings is due entirely to the timing of your contributions.
Do your best
The hypothetical examples above represent what-if scenarios that aren’t always possible to replicate in real life. For instance, you may not be able to invest the same amount each year or have to skip a few years altogether. That’s okay. Take small steps toward saving 12%–15% of your gross income (including employer contributions) each year.
Maybe you don’t have the financial flexibility to make a lump-sum investment in your IRA—in January or April (or in any other month as a matter of fact). That’s okay too. Try setting up recurring automatic bank transfers. Making biweekly contributions over the course of 30 years (for a total contribution of $165,000) and earning a 4% average annual return would result in an end balance smaller than Example A but bigger than Example B. Not too shabby.
If you’re making an IRA contribution—no matter the amount and timing—you’re on the right track. All we’re saying is if you happen to find yourself in the position to make your annual IRA contribution before following year’s tax-filing deadline, go for it.
*You can never contribute more than you’ve earned for the year.
If you’re under age 50, you can contribute up to $6,000 across 1 or more IRAs for tax year 2020. If you’re age 50 or older, the limit is slightly higher ($7,000).*
**This hypothetical example is provided for the purposes of illustration only. It doesn’t represent the return on any particular investment and the rate isn’t guaranteed. All figures are in today’s dollars. Assumes contributions on January 1 of the tax year and April 1 of the following year. Figure assumes each investor contributes $5,500 for 30 years ($165,000 total) and earns 4% annually after inflation. Source: Vanguard.