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