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As a young adult, one of the smartest money moves you can make after you begin working is investing in a Roth IRA.
If you follow a few rules, you won’t owe a penny in taxes as your contributions accumulate, nor when you take the money out during retirement. It’s almost like a free gift from the IRS. (Just make sure you understand the rules regarding eligibility, contributions and withdrawals.)
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Why invest early in a Roth IRA?
Investing early in a Roth IRA yields two key benefits:
1. Tax advantages: With this indispensable savings tool, your money — which you contribute after you pay taxes — grows tax-free. If you’re a young professional, your current tax bracket is probably lower than what it will be toward the end of your career, so contributing post-tax dollars today will likely result in more bang for your buck. Plus, you won’t pay taxes when you take the money out during retirement. On the other hand, withdrawing money from a traditional 401(k) plan at retirement will result in a significant tax burden later, because the money went in pre-tax. Having a Roth IRA gives you additional strategies to minimize your taxable income during retirement.
2. Compound interest: With compounding interest, your return is added to your principal amount, and the rate of return is then applied to that new, bigger sum. The longer your money is invested this way, the more it can grow. That means the earlier you start contributing, the better.
> MORE: How to Open a Roth IRA
Breaking down the numbers
So why not wait until you’re 35, when you’re more financially mature, to start contributing to a Roth IRA? The following example illustrates how big a difference an earlier start can make.
Let’s assume you get your first job at age 22, you contribute $5,000 each year to your Roth IRA (the limit is $5,500) and you get a 7% return on your investments. (This is hypothetical, of course; there’s no guarantee you’ll get a 7% return each year.) Thanks to compounding interest, if you do this until age 65, you would have approximately $1.2 million with no taxes due when you withdraw the money.
Now, let’s say you wait until age 35 to start contributing $5,000 each year until age 65 and saw the same 7% return. In this scenario, you would have a little less than $500,000.
In this scenario, the 22-year-old has contributed $215,000 into his or her Roth IRA, while the 35-year-old has contributed $150,000. This $65,000 variance would cost roughly $700,000 in returns over the long run.
The bottom line
In conjunction with company retirement plans, a Roth IRA can be indispensable for young workers to build wealth. These retirement accounts can also offer more investment options and better access to your money than a 401(k). Plus, if a financial hurdle trips you up, you can withdraw your contributions (not earnings) at any time, tax-free, without penalty.
To learn more about whether a Roth IRA might be a good fit for you, consider working with a financial planner. You can also find information on Roths by referring to IRS Publication 590-B.
Christopher Allen is a financial advisor with Parkworth Capital.
Image via iStock.
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