What Is a Roth IRA?
The greatest investment opportunity ever invented for young people is now 23 years old. First available in 1997, a Roth IRA is a retirement account into which a person puts after-tax money. This is different from most conventional retirement accounts (401k, 403b, SEP, SIMPLE, or traditional IRA plans) that take pre-tax contributions.
What makes this so important for young people is that it brings together two of the most powerful forces in investing: compounded returns and income tax avoidance. Young investors have the time horizon to let their money grow, and probably aren't paying much in taxes now.
Let’s deal with these two factors in order:
If a young investor makes an annual Roth contribution of $6,000 from age 22 through age 59, at a compounded annual return of 8.7%, by age 60 she will have a portfolio value of over $1.5 million1. That’s conservative. The total return of the S&P 500 from 1926-2019 is 9.5% annualized. 8.7% happens to be the worst 40 year period in US market history (1929-1968)2.
Investing has never been cheaper or more efficient. Several major brokerage firms such as Schwab, Fidelity & Vanguard will let you buy the entire US stock market at zero management or transaction fees.
A 22 year-old entering the work force this year is likely not going to be paying much in income taxes. If a single taxpayer makes $45,000 in wages, the likely Federal effective tax rate is about 8% (your mileage may vary, but this is a good working estimate). Each state has their own system - let's use Maryland for our example, where our young investor would pay about 7% in state and local taxes. 15% isn’t nothing, but it’s likely to be the lowest total taxation a middle-class person will face in her life.
A Roth IRA is particularly attractive at low current tax rates. A traditional IRA offers a tax deduction now in exchange for paying taxes later. The Roth IRA stands that logic on its head: after-tax money goes in now so that future earnings come out tax free.
Even with recent tax law changes, middle-class and higher families are paying effective tax rates of 30% or more (Federal and state) on their net income. This figure is likely higher if you live in a high-tax state, and have lost the ability to deduct state and local taxes. There is little in the political debate to believe that tax burdens on middle-class families will be significantly lower in future decades.
Can I Contribute?
The contribution limit to a Roth IRA for tax years 2020 and 2021 is $6,000. In order to make this contribution, a person must have earned income from wages or self-employment. Dividends, interest and capital gains do not count. For a single person in 2020, the ability to contribute phases out between $124,000 and $139,000 of adjusted gross income. You have until April 15 to make a Roth IRA contribution for the prior year.
A Gift That Keeps Giving
Finally, to parents of young adult children: if you’re wondering about the best way to offer a young adult a way forward in life, it’s hard to imagine more bang-for-buck than a Roth IRA. A gift to open a Roth or contribute to one will help pull them to financial independence more effectively than virtually anything else. It is a gift that will pay for decades to come.
- Based on a 100% S&P 500 index portfolio at 8.7% annualized rate of return. Assumes all dividends reinvested, not adjusted for inflation. The S&P 500 is the Standard & Poor’s index calculated on a total return basis. Widely regarded as a benchmark gauge of the U.S. equities market, this index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The S&P 500 focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities.
The index performance data appearing or referenced (directly or indirectly) herein has been compiled by the respective copyright holders, trademark holders, or publication/distribution right owners of each index. Historical performance results for investment indexes and/or categories are for illustrative purposes only and do not represent actual portfolio performance. The indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges, or the deduction of an investment-management fee, which would decrease historical performance results. Investors cannot invest directly in an index.
This post is adapted from Paul Meloan's Vested Interest blog, where it originally appeared on March 5, 2019. This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.