This post is a bit more serious than the others, but it’s also among the most important. This post is about saving for retirement—and, specifically, using a tool called a Roth IRA—to get the most from your money.
Now, I know what you’re thinking: “Do I really need to start saving for retirement this young?” “Shouldn’t I just enjoy my money for now and start saving once I have more?” I had a lot of the same questions until I started researching the importance of saving money. Since then, I’ve been thoroughly convinced that saving often and saving a lot is the best way to have money for a comfortable retirement.
In fact, a recent article in the Wall Street Journal (unfortunately, requires a subscription) found that simply saving a large percentage of one’s income is hugely important-even more important than the rate of return on that income. In other words, simply investing a larger percentage of one’s income can more than make up for less-than-stellar investment skills. Young people should certainly try to become better investors, but in the meantime, even just getting started is a great decision—one that can net the investor hundreds of thousands more in the long-term.
The “hundreds of thousands” number is not an exaggeration. Consider this example of a brother and sister, who take different approaches to saving for retirement (as adapted from this article):
The sister invests $3000 annually in a tax-deferred retirement account each year from age 20-30. She then leaves the money untouched until she turns 65. The account earns 8% annually. Her brother, on the other hand, does not begin investing until age 30, but makes a similar $3000 annual investment each year until he turns 65. His account also earns 8% annually. By the time they each turn 65, who do you think will have more money in their retirement account?
Take a moment and really consider the question. The sister started saving earlier, but she also put far less of her own money into the account. The brother started saving later, but he also put a lot more of his money into account.
It seems like the brother should have more money, right? He put in $105,000 of his own money, whereas the sister only put in $30,000. But in fact, the sister will have far more money in her retirement account—$642,000 versus $518,000. It isn’t even close; starting earlier allowed the sister to put in far less money but still come out well ahead.
Hopefully by now you’re convinced of the importance of investing: Starting early means you don’t have to put in as much in the long-run because the money has more time to compound and grow. Saving a lot means you don’t have to be an investment whiz kid to have a good amount saved up. So given your new interest in saving for retirement, what is the best way to go about saving?
I recommend using a tool called a Roth IRA to get the most out of your money. A Roth IRA is a tax-advantaged account, meaning that there are certain tax benefits to using one as opposed to a standard investment account. Specifically, you don't have to pay taxes on growth that happens within a Roth IRA, provided that the money is withdrawn only for retirement (or certain exemptions, such as purchasing a first home). Although you do have to pay taxes on the initial income you invest, that would be true of almost any use of the money. By using it for a Roth IRA, however, you allow it to turn into far more money in the long-term, and that future money will not be taxed.
There are a few requirements for using Roth IRAs, but they are pretty manageable for most young people. For one, your personal income cannot exceed $125,000 annually. Seems pretty manageable. (And if you’re disqualified by that rule, you should consider yourself already pretty fortunate.) Second, you must have taxable earned income of some kind. This can be a harder hurdle for young adults, but if you work a side-job to earn some spending money—say, at a local restaurant, as a research assistant, or something of the sort—then you likely qualify. Finally, you are limited to at most contributing $5,000 or your total taxable income, whichever is lower. (If you only earned $2,000, you can only contribute $2,000 for that year.) Beyond those rules, the requirements of a Roth IRA are pretty simple.
Of course, there’s a more practical obstacle to young adults investing in a Roth IRA—they often need their income. If you’re in a position where you need your pay to cover living expenses, pocket money, or anything else, I recommend talking to your parents and seeing if you can strike an agreement.
For example, see whether your parents will gift you the money to fund your Roth IRA in return for your repaying it after you graduate (or when you earn more money). Explain to them why investing early is so important. Draw up for them your plans to return the gift. Hopefully they will be impressed by your determination and assist you in your plans.
As long as you have still earned taxable income for the year, their gifting you the money or helping you cover expenses while you invest should be above-board. It’s important to note, however, that I’m not a tax attorney, so you should consult with one if you have any concerns or questions. Check with a local college to see if they can refer you to a free attorney for low-income adults or free financial planning. Beyond that, though, looking to your parents for help could be a viable solution.
Saving money for retirement is very important, but it’s unfortunately off the radar of most young adults. Starting early provides a big leg-up at much lower costs. Saving a lot can help to offset poor investment skills. Using an account such as a Roth IRA can help the money grow without taxes for long periods of time, helping the investor to accumulate wealth. Although it can be difficult to scrounge up the money to invest, it will pay great dividends in the long-term if you can find a way to manage.
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Photo from above is available here.
It seems a bit rash to plug Roths without talking about the tax tradeoffs vs traditional IRAs. Of course, a Roth is the only choice for those who are over the limit or ineligible for a traditional IRA, but few students are likely to be in those categories, and many/most financial planners suggest capping out traditional IRAs first. Due to the nature of compound interest, investing early is really important, as you point out, and deferring taxes is another tool for investing more money early.
ReplyDeleteHey Ryan,
DeleteThanks for the feedback. My original draft of this article actually contained a reference to Traditional IRAs, but I decided to cut it because, in my estimation, a young person is almost always better off using the Roth option. The key factor, as I see it, is whether one expects their tax rate to rise over time. Because most young people will end up paying a higher tax rate later in life, I think it makes more sense to pay the tax at a lower rate now, rather than at a higher rate later on.
I definitely agree that investing early is important and that it's good to get in more money when possible. In that case, though, I'd still want to invest my money in a Roth IRA--say, an entire $3,000 income--and just try to cover the income taxes on the $3,000 through some other means. Of course, that might not be possible. Some of the time a Traditional IRA might allow a young person to invest more upfront because they can avoid the tax cost for the year. But in general, I would aim to use a Roth IRA when possible.