I didn’t know the difference between a Roth and a Traditional IRA until I was in my mid-20s. I knew that my employer matched my contributions to an IRA but when I started no one explained to me what kinds of retirement investments there were. I had been working for years before I found out that my account was automatically putting all my contributions into bonds. Before I found out that I had to login to my account to change my portfolio from bonds to stocks, I had missed years of the largest increase in stock prices in decades.
In my 20 years of education, including K-12, college, and law school no one had taught me about personal finance and my first job didn’t bother to educate me on how the different plans worked. Learning how to handle money was something that I was expected to learn on my own. Despite already making countless errors, I continue to learn all I can about saving and do my best to pass on what I have learn. I also believe that those under 18, when they get their first job, should open a retirement account as young as they can. This will not only provide a valuable life lesson but the returns could be enormous!
Traditional vs Roth IRA
For an adult, deciding between a Roth and Traditional IRA depends on your circumstances and which plan is best might change throughout your life. Since Roth IRAs allow you to pay your federal income taxes upfront and withdraw them in retirement tax free, they are often ideal for younger people who can afford to pay the tax and expect to have a higher income during retirement. Alternatively, Traditional IRAs allow you to put money away for retirement tax free, allowing you to keep more resource now but you’ll have to pay the income tax in retirement. You should choose a Traditional IRA if your finances are tight and paying your taxes upfront would mean putting less money into their retirement account now. You should also pick a Traditional IRA if you believe that your taxes are higher now than they will be during retirement. For those under 18, it’s almost always smart to choose a Roth IRA because their income is below the amount where they would have to pay federal income tax ($12,000 for 2018).
529 vs Roth IRA
It might seem strange for me to be advocating for putting money away for retirement when students are fast approaching a very expensive time in their lives. Most Americans are born into debt and spend their lives digging out of it. Hopefully, if parents are financially able, they have opened a 529 plan for their children at birth. Even putting away $20 a month, with the magic of compound interest, will go a long way in reducing the amount of debt they have to take on when furthering their education. We won’t go further into 529 accounts, but like IRAs investing early in life provides countless benefits later on. However, even if a child is 15 or 16, and does not have a large amount in their 529 account, it may still be a good idea to start investing in a Roth IRA. With only a few years to grow, investing in a 529 will only have a few years to grow and to avoid losses you should put your investments into low-risk payments with little chance to grow. However, investing in a Roth IRA at age 15 allows you to invest in riskier investments that has the potential for much larger returns.
Why Get a Roth IRA
College, car ownership, and home ownership are some of the most expense purchases of our lives and often put many of us into massive debt. Yet, while trying to pay off those expenses we are expected to also try to save for retirement. Here is where managing the different rates between debt and interest become so important. Over a period of a person’s lifetime, the stock market will return about 7.5 percent annually on your investment. Student loans typically have, a lower interest rate than what the stock market returns, government issued student loans allow you to take a deduction on the interest, and there are companies that will refinance student loans.
Unlike 529 plans, which you can contribute to at any time, you can only start contributing to an IRA when you have actual income that is reported in a tax filing to the IRS and contributions to an IRA cannot be larger than that year’s income. For a Roth IRA in 2018, the maximum contribution is $5,500, so a child could put whatever percent of their income they wanted up to the cap.
Wowing with Big Numbers
Let’s use a hypothetical 15-year-old who has a summer job earning $10 an hour clearing tables at a restaurant, earning $2,000 over the course of the summer. Now, if the parents have $2,000 they were planning to put away for the child’s education they might instead want to put it into a Roth, rather than a 529. The 529 will only have a few years to mature and will have to be in a low risk investment, but a Roth will have another 50 years to mature and will be growing tax-free that entire time. Putting $2,000 into a Roth IRA for a 15-year-old, with a 7.5% annual return, will be worth $84,000 when the child reaches age 65, and it will be tax-free. The craziest part of compound interest is that if the child waits until 25 when they have a job and can put $2,000 into a Roth IRA it will only be worth $39,800 by the time they turn 65. Just for fun, let’s say the 15-year-old had a job that earned $5,500 a year and put every dollar of it into a Roth IRA (the maximum amount allowed). At age 65, it would be worth $230,000! (Only $110,000 if invested at age 25.)
Unfortunately, many families don’t have a spare $5,500 or $2,000 to put away and the example above is unrealistic to most American families. But every little bit of savings helps and the earlier children are introduced to finances the better they will be later in life at handling things like loans and credit card debt. A 15-year-old who puts just $200 dollars into a Roth IRA will have $8,400 of tax-free earnings at the age of 65. Put away $200 every year from ages 15–25, and you’ll have more than $65,000 in tax-free retirement savings!
Some Technical Stuff
The IRS only requires children who have earned-income to file a tax return (from employment — not allowance, investment income, etc.) if they make more than the standard deduction, which is $12,000 for 2018. If the child works at a business that provides them with a W-2 but they make under $12,000 they can open a Roth IRA even if they don’t file their taxes (but can still only invest in the Roth up to what they earned). One last thing to note, if the child holds a job that does not provide a W-2 (like babysitting or grass cutting) and they earn more than $400, they will have to pay self-employment taxes. This is a bit of a bummer but by filing their taxes it creates a record with the IRS that allows them to open a Roth IRA account, a win in the long run!
The saying that it’s a lot easier to make money when you have money is true and many of our preferential tax treatments are setup for people who have the available resources to put money away for the future. This treats those who are struggling to keep up with their bills unfairly, blocking them from being able to take advantage of our government’s saving incentives. Until the government changes how it incentives saving, Americans should try their best to take advantage of the incentives that are available to them by putting away even a little bit. It is not difficult to setup Roth IRA at any of the large investment firms; although, I have had the best success helping people setup Roths at Fidelity and TD Ameritrade. These two companies do not have minimums and you can open a Roth with a very small upfront investment. Parents should start teaching their children about saving when they get their first job, taking advantage of the magic of compound interest and the financial lesson will serve them for their entire life.