One of the best things young investors can do to ensure their future financial freedom is begin saving for retirement as early as possible. I recommend Roth IRAs to many of my clients and friends, because the way they work can be especially beneficial to young professionals.
You might have a Roth IRA account set up (and even contribute to it!) without understanding its importance. Or maybe you’ve been meaning to get around to creating one, but you’re afraid to pick the wrong investments or wonder how you can afford to contribute.
My hope is that you read this and learn how easy setting up a Roth IRA can be, and how much you stand to benefit from having one. If you have 10 minutes and know how to bank online, you can do this!
What Is a Roth IRA?
A Roth IRA is a type of Individual Retirement Account (meaning it’s not employer-sponsored, like a 401(k) is). You can contribute up to $5,500 per year, and your contributions are made post-tax — that means you’ve already paid income tax on that money.
The post-tax money part is an important benefit because your money grows tax-free and future withdrawals are also tax-free. Generally, the earlier you are in your career, the lower your income tax rate is. That means you may enjoy those tax-free withdrawals when you’re in a higher tax bracket later in life!
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How Do I Know if I Qualify?
You can contribute to a Roth at any age (even as a kid or a retiree) as long as you have earned income. However, there are income limits that change every year. If you’re a high income earner, you may not qualify.
For 2017, single tax filers who make $133,000 or more are ineligible to contribute, and they can only contribute a reduced amount if they make between $118,000 and $133,000. Married people filing jointly who make $196,000 or more are ineligible, and must contribute a reduced amount once they earn $186,000 to $196,000.
If you don’t qualify because of your income, don’t worry. You’ll still have plenty of options when it comes to saving for retirement! Two things might make you eligible for a Roth in future years, though:
- You had a lower-earning year (you or a spouse lost your job or switched to a lower-paying job, or you’re a contractor/freelancer with an unsteady income).
- You and/or your spouse contributed enough pre-tax income to your 401(k) to lower your take-home income to below the Roth limits.
Yes! Not only can you, but you should! I recommend you begin by contributing enough to your 401(k) to get the full company match. After that, prioritize making the full $5,500 contribution to your Roth IRA every year. If you’re able to do both and can save even more, increase your 401(k) contributions with the ultimate goal of maxing it out with an $18,000 annual contribution.
What are the benefits to contributing to both? You’ll get some tax diversification. That’s a fancy way of saying that you can withdraw your money from your 401(k) or Roth IRA in such a way that you end up paying lower taxes in retirement.
For example, if you’re in a higher tax bracket in retirement, you might withdraw from your Roth IRA first, since you’ve already paid taxes on that money. Or you might withdraw a small amount from your 401(k) and pay taxes on that modest withdrawal, and rely on the Roth IRA if you need even more money that year.
$5,500 Is A Lot. Where Do I Get the Money to Contribute?
I know that many young professionals struggle with juggling multiple financial priorities. By the time you pay all your bills each month, there might not be much left over.
But it’s so important to take the long view with your finances, and not just focus on today. You don’t want to realize in your 50s that you have zero saved up for retirement! Believe me, it’s much harder to catch up. There will never be a time in your life when your money isn’t mostly spoken for, so establishing the habit of socking money away when you’re young will benefit you a lot when you’re ready to retire. This is why it’s so important to get in the habit of paying yourself first.
Here are some tricks that can make contributing to your Roth IRA easier:
- You don’t have to make a $5,500 lump sum contribution. Set up smaller quarterly or monthly money transfers.
- Practice reverse budgeting. Instead of hoping you’ll have something left at the end of the month to save (after paying for needed expenses, plus some fun stuff), funnel money into retirement and savings accounts first. Next, pay your bills. You can spend whatever’s left guilt-free.
- Take advantage of bonuses, raises, tax refunds and other “lumpy” income. Instead of using them to make your life fancier, apply the extra windfall to your Roth IRA.
Roth IRAs offer flexibility beyond what you might have with a tax-deferred account like a 401(k) or traditional IRA.
Generally, you want to hold off on making withdrawals until you’re at least 59½ years old, because after that point your withdrawals are tax- and penalty-free. But if you need the money earlier, you can withdraw your contributions (the $5,500 you invest, not the earnings on that money) that have been in the account for at least five years without taxes or penalties (this is known as the 5-year rule).
You can also avoid penalties on withdrawals if you use the money for a first-time home purchase or higher education expenses.
Another benefit is the lack of required minimum distributions (RMDs). With 401(k)s and traditional IRAs, you must begin making withdrawals beginning at age 70½. This money hasn’t been taxed yet, and the government is going to want to collect!
But Roth IRA funds have already been taxed, so you can hold that money in the Roth indefinitely. This makes Roth IRAs ideal for passing down to heirs. They’ll pay no income taxes on inherited Roth IRAs, but they will need to take distributions.
A Note on Fees
As with all investment accounts, you need to pay attention to fees when it comes to your Roth IRA. Fees have a sneaky way of eating into your investment returns, and when you’re holding investments for a few decades, that seemingly innocent 1% fee can add up to hundreds of thousands of dollars you don’t get to keep!
Here are two areas to pay attention: the expense ratio (which is the cost to own the fund) and the fees you pay for an investment advisor to manage your account.
Look for funds with expense ratios under 0.5% (Vanguard is well-known for its low-fee choices). As a rule, index funds are cheaper than actively-managed funds, and ETFs cost less than index funds. Target-date funds offer convenience, but often charge higher fees for the privilege. You can find the expense ratio of any fund by looking on Morningstar.
Phew! You Made It!
Are you still reading? You’re awesome! Here’s some super easy homework for you:
- If you don’t have a Roth IRA yet and if you qualify, open an account and start saving.
- If you have a Roth IRA and you haven’t contributed the max ($5,500) for 2016, then make sure you do that before April 18, 2017.
- If you’ve already maxed out your Roth IRA for 2016, you can get started on your 2017 contributions! ($5,500).
Godspeed,
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Terry Andersen
Financial Advisor