Helping people prepare for for a successful retirement is what I do every day. A bulk of the retirees typically will have some sort of pension or retirement account that represents the majority of their investable assets. Deciding the proper strategy to do with that money is the most common thing we do and more times than not, it makes sense to roll that retirement account into a traditional IRA. When we’re deciding on an income plan with the IRA it never fails that I get the question, “How much interest does an IRA make?”. I always crack a smile when I hear this because it’s such a common question that hear, that I thought it would be best to explain how you actually make interest on an IRA.
The Best Rates On Your IRA
If you missed it before, I wrote a similar post on the topic that talked about how several people have asked me how to get the best rates on a Roth IRA. Although, this is a very similar, most of those questions were asked by people in the accumulation stage of investing and I wanted to gear this one more towards retirees.
Why So Much Confusion?
Many investors associate IRA’s with an IRA CD that you get at your local bank. Of course, CD’s just pay a stated interest rate and that’s where the confusion sets in. Unless the financial institution has a relationship with a brokerage firm, then CD’s or savings accounts are the only investment option that the IRA can have.
IRA Interest Rate = Total Return
They say a picture is worth a thousand words. Let’s see if this sketch helps paint a clearer picture on how you are able to make money on an IRA:
*Dividends are not guaranteed. Interest and bond payments are subject to the claims paying ability of the issuer and may be subject to certain terms or restrictions. Investing is subject to risk. Appreciation is not guaranteed.
Keeping it simple, most every retiree’s portfolio will consist of a portion of stocks and bonds. Depending on an array of variables to include risk profile, time horizon, income needs, etc; will determine what the right mix of stocks and bonds will be. When you have a portfolio that consists of the two, you will have two main components that will you give the total return (or interest rate, as some would call it):
- Income (from Stock Dividends, Bond Payments, Distributions) and
- Appreciation (or depreciation).
Let’s take a closer look at the two.
Income From a Portfolio
Typically, when you hear “income” regarding an investment portfolio the most common thing that comes to mind is bonds. Bonds pay what is called a “coupon payment” which is based on the stated interest rate on the bond. These coupon payments can be paid monthly, quarterly, or semi-annually- all depending on the issuer of the bond.
The other income component from a portfolio is dividends from stocks or preferred stocks. If you own a percentage of stock in your portfolio then there’s a good chance that some of the stock you own pay a dividend. According to Investorguide.com here’s a quick tidbit on stock dividends:
Dividends are determined by the company who issued the stock and they may fluctuate greatly. Dividends are cash payments that the company pays to stock holders based upon profits and are paid out on a per share basis. In other words, a business may determine that the dividend payout to stockholders for the first quarter is $.25 per share. So, a person who owns 1000 shares would receive a dividend payment of $250 for the first quarter.
The income portion of the portfolio is the closest you’ll get to a fixed interest rate on your portfolio. I want to stress that even the income portion of a portfolio can change pretty quickly based on many factors. Increasing or decreasing interest rates will have the largest effect just as they would on CD’s at your bank.
Appreciation on a Portfolio
The second factor that will contribute the return on your IRA portfolio is appreciation (or depreciation). Simply put: making money. With stocks, that is pretty simple. You buy stock XYZ and $5.00 and sell it at $10.00, you have appreciation. That is pretty straight forward. What most investors don’t realize is that appreciation potential does not just apply to stocks- you can make it on your bonds, too. Say what?
When people think of investing into bonds, they just think that you buy a bond and collect the interest. Just like a CD. While yes, that is true; most investors don’t realize that you can trade bonds in the secondary market and the value can go up or down.
Many bonds are issued at par (or face value) which is $1,000. The value of the bond has a “teeter totter” relationship with the move of interest rates. After the bond is issued, if interest rates go up, then the value of that bond will go down. Reverse the interest rate movement, and the value will go up. You’re bank Cd’s actually do this, too; you just never see it.
Other factors will be the strength of the issuer. Remember when Lehman Brothers was on the verge of bankruptcy? There bonds went from $1,000 to less than a $100 before they eventually went bankrupt.
They way you can make appreciation on a bond is by buying in the secondary market if it’s now selling below the $1,000 issue value.
Example: You buy a bond at $950 that will mature in 3 years at $1000. Not only do you get the appreciation, but you also get the interest payment, too.
Count Your Interest Blessings
As you can see, making interest on your IRA has many variables. That’s why it’s important to meet with a CERTIFIED FINANCIAL PLANNER™ professional to help make sense of your income needs to help you position your accounts to potentially make the highest rates on your IRA.
- Certificates of Deposit at FDIC insured and offer a fixed rate of return. Certificates of Deposit that are sold prior to maturity in the secondary market are subject to market fluctuation, so that upon sale an investor may receive more or less than their original investment.
- Stock investing involves risk including loss of principal.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
- Price, yields and availability of securities are subject to change. Certain call or special redemption features may exist which could impact yield.
- Hypothetical examples are for illustrative purposes only. Results will vary.