Why you needed to open a Roth IRA yesterday

I just finally opened my Roth IRA (individual retirement account) last week and set up the investment allocations over the weekend. This is years overdue. I want to help you avoid the same mistake I did. When I was in college, probably after my freshmen year, my manager at Cold Stone randomly told me to open a Roth IRA. He said if I contributed $2000 for the four years I was in college, I would have $2 million by the time I retired. I thought about it, and told my mom what he said. I had no idea what a Roth IRA was. I looked it up on Wikipedia and found a lot of confusing tax language, but I saw one thing I understood: the word “retirement.” What did I need to fund a retirement account for? I thought. I didn’t even have my college degree yet. I also thought that there was no way that this $2 million fairytale could be anywhere close to true. I forgot about this conversation and research until last year, when I started actively learning about investments. I told my students when we did the stock project not to be foolish as I was and actually open this account whenever they turned 18. But I know that they, like me, do not believe this million dollar promise.

The Million Dollar Promise

Any investment vehicle can offer you great growth if you have a long enough time line. Remember that compound interest turns on “time” being the exponent. So the larger you can make that number in the exponent, the bigger you can make your account balance. At 19 or 20 years old, my manager telling me I could have $2 million after saving only $8000 seemed truly farfetched. But I saw his claim spelled out in a Dave Ramsey article when I started teaching. The key item is that the 19 year old who started the investment account has to earn 12% interest, which is a wildly high estimation. Most experts use 8% when doing any sort of projections for retirement account values. If you use this more realistic growth rate of 8% and did the 4 years of $2000 contributions, you’d have over $266,000 at age 65. This is still way more than you put in and is a pretty fantastic value! If you were to “max out” the Roth IRA, meaning, you put in the limit of $5500 each year while you were in college, you could have almost half a million by retirement at age 60 or over a million at age 70. So as you can see, it is a great value.

My Mistakes

I did not open the Roth IRA while in college, nor did I after college. Every penny I earned while in college went toward paying for college. It was my dream and there was no way I could take money away from that cost for a retirement account I didn’t understand. So now I’ve lost out on a lot of potential growth. When I started working as a teacher, I could have opened the Roth IRA, but this time I went with the advice I got. And it was bad advice. A financial advisor visited my school and essentially said that there is no point in opening a Roth IRA now that I am in a “higher” tax bracket. Again, it took me a long while to understand why this was a mistake. I am only in the second tax bracket (15% this year, 12% next year). I did the math back in September that told me there is still a great advantage to opening a Roth at my age but waited until this past week to do it. This was decision fatigue and some serious debate about where to best allocate my funds. I was caught between saving more for my house downpayment and funding my retirement. Now that I am living in my house, I don’t have that debate to deal with anymore.

Don’t be like me. Don’t wait to open your Roth IRA. Don’t make excuses about your student loans or your car or anything. Research shows that we prefer to build our assets to paying down debt. We get happy when we see our savings go up more than we do when we see debt go down. Investing will certainly grow your assets. And no matter our political leanings, there is a small part of all of us that wants to avoid taxes. Open your Roth IRA so you can avoid paying taxes on your growing funds! As with all savings/investments, anything is better than nothing. The more you contribute now, the less you have to worry in retirement.

Tax Advantages 

A Roth IRA has a unique tax advantage compared to all the other retirement accounts out there. A traditional IRA, 401(k), 403(b), and a 457(b) are all tax-deferred accounts. This means that whatever you save, does not get taxed until you retire and start using that money. It has the advantage in present day of lowering your taxable income. You pay less in taxes now and avoid paying the rest until later. Pretty nice, right? But… you still have to pay taxes on that money. If you open a Roth IRA, you use after tax dollars. You pay taxes now and you don’t have to pay taxes when you retire. I prefer to have the latter.

Let’s think this out. If I contribute $3000 this year of after-tax dollars, that is really the same as $3490 of pay before taxes. I calculated this by considering that my effective tax rate this past year was 14.45%. As long as I have more than $3490 by the time I go to spend the money, I have won. Since an 8% rate of return would turn this $3000 into $35,028 at age 60, I’d rather pay taxes today than in retirement.

The other main consideration with tax advantages is what tax bracket are you in now vs. what tax bracket you will be in when you retire. I am in the 15% slash 12% tax bracket (this is the final year for the 15% bracket to exist, then I move into the 12% bracket under the new Republican tax law). I anticipate being in the same or a higher tax bracket when I retire. I do not believe I will ever get my spending to be low enough for me to enter the 10% tax bracket. The traditional wisdom goes that if you are going to be in a lower tax bracket when you retire, use a traditional IRA (or 401(k), 403(b), or 457(b)) in order to save for retirement. If you are going to be in a higher bracket, use the Roth IRA so you avoid that higher tax rate. If you’re going to be in the same tax bracket, it could go either way. But as I demonstrated above, I think being in the same tax bracket warrants a Roth IRA for a millennial.

The last reason I love the Roth IRA for tax reasons is that when I reach age 45 or 50, when I plan to stop traditional work, I can use the Roth IRA for a Roth conversion ladder. It’s a tool to help get money from those tax deferred accounts into the tax free Roth account. It’s a sweet, legal maneuver to help you pay even less in taxes. I won’t be explaining that today. Visit the Mad Fientist for the explanation.

Back Up Emergency Fund

If you are anything like me, you have been thinking through this whole article, “what if I need this money now? or soon?” Right? I know. That was me in college. I couldn’t invest because I had that money earmarked for my tuition. But now you’re more in a situation where you don’t have a specific reason in mind to spend money, but you’re worried you might need to. Still contribute to the Roth. While a Roth is a retirement account which is designed to be used after age 59.5, you can get your money out if you want to do so. Anything you contribute is yours to take back. It’s the growth that will be penalized if you try to take it out. Just about all retirement accounts have a 10% penalty if you take the money out early. However, a Roth IRA allows you take out any money you have put in, since you’ve already paid tax on it. It’s just the increase in value that you must wait until 59.5 to access or else pay a penalty.

Let’s say my $3000 I contribute this year I want back 10 years from now. Based on 8% growth over 10 years, this money should be worth $6476. I can take my $3000 out if I need it to cover some emergency. I cannot take the growth of $3476 without penalty. There are some exceptions to the penalty rule, like becoming disabled or using the funds to pay for your first home.

The fact that I can get my money back makes me much more comfortable contributing to a Roth IRA, especially being a new homeowner. I don’t have a true emergency fund of 6 months worth of expenses in a savings account, but my savings accounts plus my Roth will actually come close. Withdrawing from the Roth is an absolute last resort, but that’s what an emergency should be: spending money because I need to and I have no other option to deal with the problem.

How to invest the Roth IRA funds

At this point you should be ready to research more about opening a Roth IRA. You are probably wondering how you’ll actually make your money grow into these big numbers I keep mentioning. As we explored in the Invest Like a  Professional series, you want to choose low cost index funds. This helps you maximize your growth because you pay very little in expenses. Warren Buffet recommends a 90/10 split between stocks and bonds. While I did choose this split for my 457(b) account I just opened, I decided I wanted to be just a little more conservative and go 85/15. This is still an aggressive portfolio profile. What you choose will depend on your own risk tolerance. What can you handle? The 8% I’ve mentioned is an average. Some years, like lately, there might be 16% growth in your chosen fund. Then there will be some years with negative growth. You’ll “lose” money. But you only lose it if you sell rather than wait for the portfolio to rebound. Figure out your own risk tolerance by taking a Risk Profile Questionnaire. I am comfortable being very aggressive right now considering that I am only 27. As I near the point of wanting to use these funds, I will dial it back to 60/40 or maybe even 50/50. We’ll see when I get there, but that is still at least 19 years from now.

My Roth IRA

I of course used Charles Schwab to open my account. They have the lowest expense ratio for the two most popular index funds: the S&P 500 and the Total Stock Market index. Their expense ratios stand at 0.03% and both of these made it into my portfolio.  I opened with the one time minimum of $1000. Your other option is to open with automatic payments of $100 a month and you don’t have to use the minimum of $1000. When I get my tax refund, I will be immediately adding that amount into my Roth IRA and I plan to incorporate regular contributions as soon as my finances smooth out.

Symbol
Fund
Expense Ratio
My Allocation
Type
SWPPX S&P 500 0.03% 15% Stock
SWTSX Total Stock Market Index 0.03% 50% Stock
SWSSX Small Cap Index 0.05% 10% Stock
SWISX International Index 0.06% 10% Stock
SWRSX Treasury Inflation Protected Securities Index Fund 0.05% 10% Bond
SWAGX U.S. Aggregate Bond Index Fund 0.04% 5% Bond

 

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