In Your 20s? Reasons To Get A Roth IRA Now
When you're in your 20s, retirement is usually the last thing on your mind. Most young Millennials are more concerned with managing their student debt and beginning their careers post-graduation.
What many fail to realize, however, is that they have one of the most valuable retirement-building assets during their 20s – time. But where do you begin if you have little to no prior knowledge about retirement planning?
We'll show you why a Roth Individual Retirement Account (commonly shortened to Roth IRA) is a popular retirement vehicle for consumers looking for tax-free growth and withdrawal options for their nest eggs.What Makes a Roth IRA Unique?
There are technically 11 types of IRAs, but the two most popular types are traditional and Roth IRAs.
The biggest distinction between the two is how they're taxed. In a traditional IRA, you don't pay taxes on your funds until you withdraw them, at which point the money will be taxed as regular income. This is because in most cases when you put the money in, you are taking a pre-tax deduction for what you contribute (up to a specific permitted annual amount, which may vary due to filing status and income level). What you are doing is postponing – with the government's permission – the tax you owed on your income and any tax on what the money earns while it's in your tax-sheltered IRA. But when you withdraw your money, the taxes must be paid.
On the other hand, contributions made to a Roth IRA happen after you've already paid taxes on the income. This means you can withdraw both your original contributions and their gains tax-free (as long as you've had the account more than five years and are over age 59½).
Traditional IRAs require you to start withdrawing money by April 1 following the year in which you reach age 70½ years old. These mandatory withdrawals are known as required minimum distributions, or RMDs. If you don't take distributions at that time, you could pay a penalty of 50% of the RMD not taken.
However, with a Roth IRA, there are no RMDs until after you die when your heirs have to take them. According to the late Senator William Roth of Delaware, the father of the Roth IRA legislation, If you work hard and save hard, you can have a good retirement income that allows you to leave something to your children.Why Start Contributing in Your 20s?
Regardless of whether it's a Roth IRA, traditional IRA or a 401(K) you're contributing to, investing young means you have the advantage of time for compounding interest to work its magic. These examples will show why. Suppose that instead of investing, you simply put $100 under the mattress every month; at the end of forty years – when you're in your 60s – your lumpy mattress will lie on a nest egg of $48,000.
The magic of compounding, in an ideal world, is the mathematical reason your money grows at an exponential rate, meaning the actual rate it increases becomes greater and greater over time due to money earned being added to the principal every time the earnings are deposited into the account. It is called compounding because over time, you earn on the reinvested earnings as well as the original principal. (For more, see Investing 101: The Concept of Compounding.)
Let's illustrate this. If you start saving $100 a month beginning on your twentieth birthday, and your account averages 1% growth a month, you'll have roughly $23,000 by age 30. If you continue saving at the same rate, averaging the same returns, you'll have more than $98,000 by age 40, about $350,000 by age 50 and just over $1.17 million by age 60.
Let's say, though, that you wait until you're 50 to start saving for retirement. Your income is higher and you can afford to contribute $6,500 a year (the maximum annual contribution for people age 50 and up, which amounts to about $540.00 a month). Let's also assume you average 1% growth per month. By age 60, you will only have about $124,600. Even though you contributed much more than $100 a month, you have given yourself much less time for compounding to make your money grow.
This, above all else, is why it pays to begin investing for retirement as soon as possible.Other Benefits to the Roth IRA
- Tax-free gains – Remember that taxes don't apply to earnings in a Roth IRA. This means that you could ultimately save thousands of dollars in taxes when you ultimately begin withdrawing money.
For example, if you invest $100,000 of your own money over the life of your traditional IRA, and that investment grows to $500,000, you'll be paying taxes on withdrawals that include both your original contributions and your earnings.
However, if you had a Roth IRA that grew from $100,000 to $500,000, you already paid taxes on that initial $100,000 – the extra $400,000 in gains is yours to keep tax-free.
Protection against future tax hikes – We can't predict what Congress will do in the future, but contributing to a Roth IRA protects you from future tax hikes since you have already paid taxes on your contributions.
Penalty-free withdrawals – You can withdraw your contributions in a Roth IRA at any time without having to worry about penalty fees or taxes (see How to Use Your Roth IRA As An Emergency Fund). But if you want to do this with your gains (the income your contributions have earned), you'll need to wait until you're 59½ if you want to do so without penalty.
Remember that people who make over a certain income ($129,000/year if you're single, head of household, or filing separately) are unable to contribute to a Roth IRA. This just underscores why you'd be smart to take advantage of a Roth IRA now, since you're probably not earning $129,000 a year during most, if not all, of your 20s.The Bottom Line
The sooner you start saving/investing for retirement, the better. Compounding gives you the opportunity to rapidly grow your assets if you have plenty of time on your side.
You might not be making much money in your early 20s, but a little saving today – even if it's just $100 a month – will greatly increase your chances of becoming a millionaire by the time you finally retire.