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“Market Timing” for Your IRA: The Early Premium

Want to know a simple strategy that can help you end up with thousands more by properly timing your investment into your IRA?

Dan Egan

By Dan Egan
Managing Director of Behavioral Finance & Investing, Betterment
Published: October 24, 2014 | Updated: May 10, 2018

Invest at the beginning of the year—rather than at the last minute in April to get more time in the market and potentially more returns.

For those younger than 50, the current IRA contribution limit is $5,500.

Time and time again, Betterment and many other financial advisors highlight the overwhelming evidence that market timing doesn’t work. But there’s a one exception: contributing to your IRA as early as possible.

Each year, any investor younger than 50 can contribute a maximum of $5,500 to an IRA (and that maximum can change over time). It’s your choice to make a $5,500 deposit on January 1, to contribute over time, or wait until the deadline. By timing your contribution to be as early as possible, you can maximize your time in market, which could help you gain more returns over time.

This timing strategy is so powerful, that historically, any investor who hypothetically could have contributed to their IRA since 1928 would have left an average of $14,600 on the table over any 10-year period (see Figure 2 for the evidence).

Sounds too good to be true? Learn how this form of market timing really works.

How IRA ‘Timing’ Works

Currently, everyone has a 15-month window during which you can max out contributions to an IRA. You have from the start of a calendar year until the federal tax filing deadline to make your contribution. If you save up and max out your IRA contribution at the beginning of the year, instead of the April of the following year, it gives each installment an extra 15 months to grow. If market performance goes up, you can expect greater growth with more time in the market.

To test how well this strategy could have worked throughout history, let’s compare it to the default strategy for most people—waiting until April (tax time) to max out the previous year’s contribution. For those younger than 50, the current IRA contribution limit is $5,500. This example will be completely hypothetical, using S&P 500 index data to illustrate what historical performance for IRA contributions could have been like (see figure captions below for more information).

First, imagine making the annual $5,500 investment on April 15, the last possible day to contribute for the prior year—every year for 10 years. Let’s assume you invest it all into the S&P 500 index; we’ll measure the value of this imaginary S&P 500 portfolio immediately after the last contribution. From there, let’s simulate the performance for every ten-year period since 1928.

As comparison, let’s do the same thing but make each annual investment in January, 15 months earlier—the first possible day to contribute for that tax year. Again,  for each simulation, we’ll measure the portfolio value on the same day as in the first scenario.

On average, investing as early as possible would have resulted in a $14,600 higher account balance in this hypothetical historical example using S&P 500 data. Considering we’ve invested just $55,000 in both scenarios, that amounts to an additional 26% on the invested principal, as compared to the next-year-at-tax-time strategy.

Below, you can see this historical benefit of giving each of your contributions an extra 15 months in the market. Any extra growth can then compound over the entire life of each annual investment.

Value of Early IRA Contributions

Average gains on ten annual contributions of $5,500

IRA max out early

Figure 1. This figure uses the historical performance of the S&P 500 index from 1928 to 2015 to show a hypothetical historical balance for $5,500 being deposited into an IRA every year for rolling ten-year periods. The S&P 500 is not comparable to any Betterment portfolio, and does not represent any Betterment customer’s likely return. However, as a widely reported index, it is demonstrative of how many investors view U.S. stock market performance. Historical market performance is not indicative of future performance, and this figure does not take into account dividend reinvestment or taxes upon withdrawal from an IRA. Since the performance data is from the S&P 500 index, fees were also not included. Data from Yahoo Finance.

Now, of course, that’s just an average. So let’s look at this “early premium” for each ten-year period individually—the dollar difference between making each contribution as early as possible versus as late as possible.

The graph below shows that you almost always would have won when investing early compared to late. The “early” investors who caught the Great Depression and a combination of the dot-com crash and the 2008 financial crisis did a bit worse, but the downside was at most about $4,000.

The upside, however, was overwhelming. Sometimes it really paid off to invest early—up to nearly $40,000 more (on just $55,000 of contributions).

Value of Early IRA Contributions by Year

Rolling ten-year periods (beginning each year 1928-2015)

maxing out IRA early

Figure 2. This figure uses the historical performance of the S&P 500 index from 1928 to 2015 to show a hypothetical historical balance for $5,500 being deposited into an IRA every year for rolling ten-year periods. The S&P 500 is not comparable to any Betterment portfolio, and does not represent any Betterment customer’s likely return. However, as a widely reported index, it is demonstrative of how many investors view U.S. stock market performance. Historical market performance is not indicative of future performance, and this figure does not take into account dividend reinvestment or taxes upon withdrawal from an IRA. Since the performance data is from the S&P 500 index, fees were also not included. Data from Yahoo Finance.

Look at that—a timing-based investment strategy with huge upside, and a small downside. Now, past performance can never guarantee future results, but nearly 100 years is quite a sample size.

How can you start benefiting from this strategy? Max out your 2017 IRA contributions as soon as possible, and start saving up for your 2018 IRA. When Jan. 2, 2019, rolls around, max out your 2019 IRA.

Why Jan. 2? Even stock markets take New Year’s Day off.

 

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