So far in my life, I have had some pretty stellar jobs (one year I wrote “shark wrestler” when describing my job to the IRS on my tax forms).
Stellar jobs, yes…but so far no 401k has come my way. I am very aware that investing early will lead to much more wealth in retirement because of the miracle of compound interest. I don’t want to miss out on that extra giant pot of money, but how are you supposed to save for retirement without a job that gives you benefits?
The answer is a Roth IRA. It is named after Senator William Roth (DE), who led the fight to help create this awesome savings tool. IRA stands for Individual Retirement Account. Not so tricky!
A Roth IRA is the best choice for twentysomethings. A Roth IRA is a diversified set of investments (similar to a 401k in this way), but the biggest difference between a Roth IRA and a 401k is that a 401k is funded with pre-tax money, and then you are taxed when you take the funds out. A Roth IRA is funded with money you have already paid taxes on. You let the ca$h money sit in there for at least 5 years, and when you take the money out (as long as you are older than 59 1/2) YOU DO NOT HAVE TO PAY ANY TAXES ON IT. NONE. You don’t even have to pay taxes on the compound interest that you have earned. This is an awesome deal!
There is also something called a traditional IRA, but if you are young and expect to make a ton in compound interest (which you do)- then go for a Roth IRA. A traditional IRA is funded by money that is not taxed when you put it in, but when you take the money out you pay normal income tax.
I am a full-fledged Roth IRA fan but there are (very few) reasons why you would choose a traditional IRA instead.
- Roth IRAs have income limits. If you make over $95k individually or $150k as a couple, you can’t get a Roth IRA. So go with traditional.
- If you are making a lot of ca$h money now, but you expect to be in a lower income bracket when you retire, you can save on your tax bill by not paying taxes on your investment now (in the higher bracket) and paying them later (when you retire). If you are in your 20s, however, your interest should be massive and you will pay a lot of taxes on that interest (and also can you say for certain what kind of money you will be making when you retire? Please. Just go for the Roth IRA)
Are you convinced a Roth IRA is an excellent choice? Me too. Here are some things to know:
- In 2014, you can contribute up to $5,500 to your Roth IRA each year. The more you invest at an early age, the better your compound interest will treat you!
- If you are married, both you and your spouse can have a Roth IRA even if you only have one income (which means double the potential for investing!)
- You can always take out the initial contribution that you had invested without penalty. This makes the Roth IRA kind of like a secret savings account for yourself- except compound interest is so good I do not recommend that you do this except in extreme emergencies (you have already tapped out all of your other savings accounts)
- You can set up your Roth IRA to automatically reduce the risk in your portfolio as you get closer to retirement, so you don’t even have to worry about anything. I just picked that option when I opened my Roth IRA and I don’t ever have to fiddle with it (unless I want to, of course!). Extremely low maintenance.
If you want to take out more than your initial contribution (the interest that your money has earned) you will pay a 10% penalty if you are not 59 1/2 yet unless you are taking it out for any of the following reasons:
- Educational expenses
- Medical expenses that are over 7.5% of your adjusted gross income
- First time homebuyers can take out up to $10,000
- Costs of a sudden disability
So you still have access to all of this money in case of a big emergency. However, if you spend your retirement what will you do when you retire? Also, remember that each $1000 you put in today could be worth over $10k when it is time to retire. I don’t want to rob my future self of that easy money! I pretend that the money is GONE and I have promised myself that I am not touching it. It does make me feel better, though, to have a source of backup funds just in case all of my other financial strategies get tapped out.
Stay tuned for next time- we can talk about HOW you actually set one of these suckers up.