Why Roth IRAs are great for young earners (part 1)

A Roth Individual Retirement Account (Roth IRA) can be a great investment for young professionals. Roth IRA tax advantages are often best for young earners who may not benefit as much from the tax breaks of a Traditional IRA.¹ Roth IRAs also offer more flexibility than most other retirement savings accounts. Plus, starting your retirement savings when you’re young gives your funds decades of dividend compounding, improving the odds that you’ll build up a healthy nestegg.²

Younger earners don’t generally pay high income taxes

With a Traditional IRA or a standard, pre-tax 401(k) contribution, your taxable income is reduced now, so you save on current income taxes. But because many young earners just starting their careers are at the lower end of the tax bracket spectrum, the tax benefits of pre-tax contributions would likely benefit them more later on in their career when their incomes have increased.¹

That’s why many personal finance experts recommend the savings formula outlined below for young earners – but keep in mind that it’s just a rule-of-thumb guideline, so it may not be best for your individual circumstances, and you should talk to your tax advisor and financial consultant to figure out which route may be best for you:

• Maximize your company’s 401(k) match. Contribute enough to your workplace 401(k) so you get the maximum amount of company matching funds. So for example, if your employer matches 50 percent of your contribution up to three percent, you’d contribute six percent yourself and your company would contribute three percent. If your employer matches dollar-to-dollar up to five percent, you’d contribute five percent of your salary and your company would match that five percent.
• Contribute to a Roth IRA. Although it doesn’t reduce your taxable income now – because you contribute to a Roth with the dollars you’ve already paid income tax on – it gives you tax diversification later. Contributing to both a pre-tax 401(k) and a Roth IRA could provide both taxable 401(k) income and tax-free Roth IRA income in retirement.^1,2 Plus, it gives you flexibility if you need funds before your retirement. You can contribute up to $5,500 each year ($5,500 for each partner if you’re married and filing jointly).³
• Contribute more to your 401(k). If you’re a young earner who is fortunate enough to be able to meet your company match threshold and max out your Roth IRA – and you’ve already met more short-term savings needs like an emergency fund – use the additional funds to contribute more to your workplace 401(k), and max it out if you can. Most young workers are allowed to contribute up to $18,500 into a 401(k) each year.³

Roth IRAs offer flexibility

I mentioned above that Roth IRAs offer flexibility if you need funds before you retire. Why? Because you’ve already paid income taxes on the money before you made your Roth IRA contribution, the IRS lets you withdraw the money you contributed at any time without having to pay taxes or IRS penalties.

Use your Roth IRA as an emergency fund

Being able to withdraw the money you’ve contributed makes a Roth IRA a great backup emergency fund. You don’t want to use your Roth IRA to pay for a flat tire or other minor event – that’s what your regular emergency fund is for. But you can have peace of mind knowing that you have your Roth IRA contributions as a backup in case of a major hardship like an extended period of unemployment or a major health crisis that can sometimes wipe out even the most robust of regular emergency funds. (Note: If you completely empty your Roth IRA, including your earnings, you’ll have to pay taxes and penalties on the amount you’ve earned unless you meet specific criteria like becoming completely disabled.)⁴

Use your Roth IRA to save for college

A Roth IRA can be a great vehicle for young parents to use to save for their children’s educations. Roth IRA dollars (both your contributions and earnings) can be used, tax- and penalty-free,⁵ for any “qualified educational expense.” And if your child ends up being a brainiac or an all-star athlete who gets a scholarship to cover college, you can keep the money where it is and let your Roth dollars continue to compound until you need them in retirement.
Pro tip: When student financial aid calculations are made, Roth IRA balances generally do not count as money that you are expected to contribute toward college costs – until you start to use them. For that reason, some people wait to use their Roth savings until their final year of school; that way, they may get more financial aid during their underclass years.

Use your Roth IRA to buy your first home

When you buy your first home, you can use your Roth IRA contributions for a downpayment if you need extra funds. You can also use $10,000 of your contributions tax- and penalty-free if your account has been open for five years; if it’s a newer account, that $10,000 is considered taxable income.⁴  

Potential for decades of tax-free growth

Starting a Roth IRA early gives your retirement savings more years to compound and grow. There are of course no guarantees of any return at all when you’re talking about stock investments, and our recent wild ride of market ups and downs has certainly reminded investors of that fact!

However, if you look at estimates based on a seven percent stock market return rate, you can see the potential value of decades of compounded growth. Part two of this series on Roth IRAs for young earners will go into more detail about how compound growth benefits the young, but here’s a quick summary:

Let’s say you’re a 22-year-old and you open a Roth IRA and contribute the 2018 maximum of $5,500* every year through age 65, which is a total of $236,500 in contributions. If that Roth IRA earns seven percent each year, you’d end up with a balance of $1,460,000! That’s the potential power of decades of compounded growth.² 

<sup>* Keep in mind that the IRS reevaluates and adjusts the maximum contribution limit annually based on inflation, so if you started maxing out at $5,500 now and increased your contributions as the IRS raised its contribution limits, you’d end up with even more than this $5,500 contribution shows.
1. The information in this article is for general information only and is not intended to provide specific advice or recommendations for any individual, as each individual's tax situation and investment risk tolerance is different. To determine which investment(s) may be appropriate for you and how you might potentially reduce your taxable income now or in retirement, consult with your tax professional and financial advisor to discuss your personal situation prior to investing.
2. Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of or guaranteed by the financial institution.
3. The IRS limit for contributions to Traditional and Roth IRAs in 2018 is $5,500, or your total earned compensation, whichever is less. In other words, someone who earns $3,500 in 2018 could only contribute $3,500 to an IRA. Eligibility to contribute to IRAs is subject to IRS income phaseouts. The 2018 Roth IRA Modified Adjusted Gross Income (MAGI) Limit is $199,000 for married couples filing jointly and $135,000 for singles. Couples who are married filing jointly can max out contributions to IRAs for both spouses as long as the working spouse’s income is more than the total amount contributed. For example, under current contribution limits, you can contribute up to $5,500 to each spouse’s IRA (subject to IRS income phaseouts) if the working spouse makes $11,000 or more that tax year. Each person must open his/her own IRA. Consult with your tax advisor for additional tax information.
4. You can withdraw any funds you contributed to the account tax- and penalty-free. If your account has not been open for five tax years, withdrawals of account earnings are subject to income tax and early withdrawal penalties (unless your emergency is a qualifying event such as becoming permanently disabled). If your Roth IRA has been open for five tax years, distribution of $10,000 of your earnings to fund a first-home purchase is not subject to income taxes or early withdrawal penalties. If your account has been open for less than five tax years, the $10,000 is not subject to early withdrawal penalties, but it is taxable income.
5. The IRS defines qualified expenses as “amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution.”</sup>

Pam Leibfried is a marketing content specialist whose love of words led to a writing and editing career. After a brief stint teaching English, she transitioned to corporate communications and spent 20 years at The Nielsen Company before joining Alliant's content development team. Early in her work life, Pam's friend Matt explained the benefits of a 401(k) and her dad encouraged her to start a Roth IRA. Their good counsel prompted her to prioritize retirement savings, which just might enable her to retire early so she can read more and live out the slogan on her fave T-shirt: "I have a retirement plan: I plan on quilting."