The future is, for the most part, uncertain. Sometimes that can be scary, but often it is exhilarating. It all depends on how you look at it. While I can’t really say where I’ll be next year, I’m pretty certain that when I get to (if I make it) to 60+ years of age, I’m going to stop working hard, and retire to making sandwiches at a deli/bagel shop, or stocking produce at the supermarket. I’ll do these things not to get away from my lovely bride (TBD) of 30+ years but because they are things I enjoy doing, and they provide an honest, though incredibly modest income. I don’t plan on descending into a sedentary lifestyle at this age, so how will I fund fun, excitement, and Viagra come 2048?
Enter the Roth IRA. It’s a fairly new (1997) investment vehicle that can help prepare you for the distant (or not so distant) future. A Roth IRA stands apart from other investments in the form of an incredibly beneficial tax break.
Assume you are 25 years old, currently working full-time (kudos to you), earning $45,000/year. You are able to contribute $5000 per tax year to a fund of your choice, whether it be a CD, mutual fund, or stock. The marvel of compound interest allows your money to grow, and if you continue putting in $5000/year for the next 40 years, assuming a rate of return of 8%, come age 65, you’ll have banked nearly 1.4 million dollars. Hopefully this is padded by your 401(k) and/or pension, and your gig at Stop & Shop picks up the rest. Your $200,000 principle has matured into a much larger sum, assuming this long term growth rate. Whether we can expect that rate over the course of the next 40 years is debatable; current models of markets are being reviewed and revised, and all the things regarding growth that we assumed as givens are being tested.
So why are you better off in a “Roth IRA” instead of just investing into a regular index fund? The Roth IRA, both principle and interest you earn, are tax-free and penalty-free. Instead of paying a large portion of this sum back to the government in taxes upon withdrawal, it’s all yours. While taxes may not seem like a big deal, 20% of a million dollars is a lot of money you’ll have to pay back to IRS. The money istaxed before you invest it, like any stock investment you’d make on your own anyway.
Another benefit – There is no tax or penalty if you need to withdrawal any or all of the principle (after 5 years of opening the fund). So you turn 32, and decide that the $35,000 you’ve invested would be much better in your buddy’s brilliant startup. Pull it all out, and give him the $35,000. No questions asked.
If you are buying your first home, you can pull out up to $10,000 of the earnings in addition to the principle without penalty. A great deal in itself.
The sooner you start, the better. Forgoing a few years can mean forgoing thousands upon thousands of dollars. Step one? Open an account with a brokerage (if you haven’t one already) like Fidelity, TDAmeritrade, or Vanguard. You should be able to follow the simple steps from there and make your first contribution. Intimidated by the internet? Pick up the phone and call one of these companies. As they will be managing your money, they are more than happy to help you get started.
What to invest in? That’s a story for another day. Many brokerages run life-cycle funds, an investment that adjusts risk according to your age (e.g Fidelity Freedom Fund 2050). The money is managed for you; all you need to do is pick your estimated retirement year and you’re set. Even if you are a speculative investor and enjoy buying a selling stocks frequently, you can do this within your Roth IRA and not pay tax (up to 35%!) on the capital gains or dividends.
The one certainty is that you will need money when you retire. Take those idle minutes at work, close Gmail and Facebook, and do just a bit of research on this. Plan on opening the account and making your first contribution this week, even if its a small one. The first step is the hardest to take. Barring a 2012 apocalypse, you can look forward to turning in that application at the bagel shop with pride, satisfaction, and piece of mind. Get to it.
Email me with any questions.