Lump Sum or Dollar-Cost Averaging: How Should You Contribute to Your IRA?

Putting money aside for your retirement purposes is a central tenet of personal finances. IRAs in particular offer a great opportunity to do so, as they are are tax-advantaged accounts that will allow you to save for your for you future needs. Should you contribute to these funds in one lump sum or via dollar-cost averaging at regular intervals throughout the year?

Maxing out your annual IRA contributions is a strong way to save for retirement. The manner in which you do so also contains implications to consider.

What Is an IRA?

An IRA is an individual retirement account, which is a tax-advantaged savings account that allows you to put money away for the future. There are two different types of IRAs: Roth and Traditional IRAs.

With Roth IRAs, you will put after-tax money into your investment account. These monies will then grow tax-free, and assuming that you only withdraw them after you are 59 1/2 years old, you can enjoy any investment gains without paying any additional tax.

With traditional IRAs, the order of the tax benefits is flipped. The contributions that you make to a Traditional IRA are made with pre-tax funds, which allow you to deduct this amount from your annual tax obligations. However, you will be taxed on the investment gains when you withdraw these monies in your retirement years.

Both types of IRAs have the same annual contribution limits. For 2024, annual contributions to IRAs are capped at $7,000. If you are older than 50 years old, you can contribute $8,000 per year.

Regardless of the type of IRA that you go with, both of these options can help you build your wealth over time, giving you peace of mind during your later years.

What Is Dollar-Cost Averaging?

Dollar-cost averaging is an investment strategy that will allow you to take the volatility out of your investments. By following this approach, you will devote a set amount of money into a specific asset or asset class at predetermined intervals.

For instance, let’s say that you are convinced that investing in Apple (NASDAQ:AAPL) is the right approach for you. You have decided to adhere to dollar-cost averaging, purchasing $500 worth of Apple stock every month. When Apple stock goes up, your $500 will purchase fewer shares; when the stock decreases, your $500 will be able to acquire more shares. Regardless of the price, you are investing the same amount every month.

By following this strategy, you will average out the price at which you are purchasing the Apple stock (or whichever asset you elect to invest in). This approach is often considered a safe and conservative one, as you will avoid the risk of putting a disproportionate amount of your money into the market at inopportune times.

TipRanks’ dollar-cost average calculator allows you to experiment with different monetary values, assets, and timeframes to understand how this approach can help you build wealth over time.

What Is Lump Sum Investing?

Lump sum investing is exactly what it sounds like. Once you have decided on the assets or asset class that you wish to invest in, who will place all of your money at one time in one lump sum.

Assuming that you have the means at your disposal, there are certainly merits in putting your entire annual contribution into your IRA at the beginning of the year. This will allow you to take advantage of compound interest, giving your money more time to earn and grow.

However, there is a danger in putting your entire basket of eggs into the market at one particular point in time. Markets go up, and markets go down, and there is no way to know for sure that you have invested at the right time.

It is certainly a possibility–and therefore a risk–that you could place your entire investment in the market just before it starts to tank. The opposite could occur as well, and your wealth could skyrocket as the market takes off. You simply cannot know beforehand.

Compound Interest vs. Market Volatility

The frequency at which you decide to contribute to your IRA is entirely up to you. You could max out your contributions on January 1st, break them up into monthly contributions 12 times a year, or find another time frame of your choosing.

The benefit of putting a lump sum of money at the start of the year is that you will give your money more time to work. The benefits of compound interest rely upon time and patience, and the longer your money is in a position to earn revenue, the more your wealth can increase. Of course, if your IRA is invested in mutual funds that inch upward throughout the year, it would make sense to invest as early as you can.

However, investments are not savings accounts, which have a locked-in rate of return. Especially if you have chosen an IRA that is highly invested in equities, your portfolio could sway in both directions. While historically, the stock market has gone up, there is no guarantee for how your particular investment will perform. You could put your entire $7,000 contribution into your IRA on January 1st and then watch as the market sinks and your investment loses value.

Dollar-cost averaging would, therefore, allow you to avoid this type of dramatic loss by spreading out your contributions throughout the year. It is a less risky approach, but you will also forgo maximizing the ability of compound interest to work its magic.

At the end of the day, this choice boils down to both your means (if you can comfortably contribute $7,000 or $8,000 at the start of the year) and your comfort level with risk.

Conclusion: Long-Term Outlooks

The best way to build the value of your IRA is by consistently investing in it. Whether you do this multiple times a year or just once, the key point is to continue making contributions throughout your income-earning years.

The frequency with which you add to your IRA is less important than the simple act of maximizing your annual contributions if you are in a position to do so. That is more important than whether you do this once a year, or once a month.

Learn money management, and use data-driven stock insights with TipRanks.