Starting a Roth IRA in your 20's is arguably one of the best financial move's you can make for yourself.
One of my goals as a financial advisor is to help open up a Roth IRA for everyone I know. Ambitious, I know, but hopefully, that helps show how valuable I think a Roth IRA truly is.
Let’s start with the basics, what even is an IRA and how is a Roth IRA different?
An IRA is an Individual Retirement Account and can be opened up by anyone with earned income. It is a personal saving account solely funded by yourself, to be used when you retire. If you pull money out before age 59 ½ you will be hit with an extra 10% penalty fee. Even if you already have a 401(k) at work, you can still open up an IRA. You are allowed to contribute up to $6000 to your IRA annually (as of 2019) up until age 50, then the allowed contribution increases to $7000 annually. This description also applies to a Roth IRA, but there are some key differences.
Taxes. If you’ve been contributing to a 401(k) or 403(b) through your employment, you might be aware of the tax benefits these accounts have. The money you put in is pulled from your paycheck before it is taxed, meaning you get to write it off when you do your taxes, making your actual income smaller, thus, your tax burden smaller. The money in your IRA will also grow tax-deferred, which can be a great thing...until it’s time to take it out. That’s when you pay your taxes. This is great if you think you will be in a lower tax bracket when you are retired than you are now, which is the case for many retirees, however, we can’t predict what the tax rates will actually be when we retire.
Historically, we currently aren’t looking too bad when it comes to taxes. The brackets range from 10%-37%
Paying taxes is never fun, we can all agree that the less we pay, the better. But you don’t have to look very far back to see that the tax rates were once much, much higher.
In 1986, the highest tax bracket was 50% and started at an income of $88,270 for single filers.
In 1981, the highest was 70%, beginning at $108,300 for single filers.
In 1964, the highest was 77%
And in 1944 and 1945....94%
Considering we have no idea what kind of tax brackets we will have when we are retired, wouldn’t it be nice to pay taxes now, at today’s known, and historically low rate?
That is the whole purpose of the Roth IRA. Contributions are made with after-tax dollars, enabling you to pull the money out in retirement tax-free. You are simply trading the time of when you pay your taxes-today, instead of 30, 40 or 50 years from now. The tax bracket you’re in when you’re in your 70’s won’t make a difference to the money you pull out of your Roth, because you already paid taxes on it. Pulling it out of a traditional IRA, however, you will be taxed at your highest nominal rate, whatever that may be.
Required Minimum Distributions, or RMD’s, is the next difference between a traditional IRA and a Roth IRA. Traditional IRA’s require you to start pulling money out at age 70 and a half, even if you don’t need it. There is a formula to calculate the amount you need to take each year from age 70 until you die or there is nothing left in the account. Your RMD’s count towards your taxable income.
There are no RMD’s with Roth IRA’s. Since you already paid taxes, the government isn’t going to get a cut of what you take out, so they don’t have any reason to force you to take distributions.
Age limits for contributions also differ. Coinciding with the Required Minimum Distributions, you are no longer allowed to put money into your traditional IRA once you reach age 70 ½. However, there is no limit for Roth’s- you can contribute as long as you have earned income. So if you’re still earning a paycheck at age 75, nothing is stopping you from maxing out your annual Roth IRA contribution of $7000.
Income phaseouts are applied to Roth IRA’s, for the 2019 tax year, people filing individually must have a modified adjusted gross income (MAGI) of under $137k in order to contribute to a Roth, but contribution limits are reduced if your MAGI is $122k or higher. For a couple filing jointly, your income must be under $203k to contribute, with reduced contributions if your MAGI is $193k or higher. If your income exceeds these limits and you still want to build up a Roth IRA, there are other options available, such as conversions and “Backdoor Roth IRA’s”.
Inheriting an IRA, or if your spouse or children inherit yours, also brings a different set of rules when looking at traditional vs. Roth. The main difference is again, taxes. If you leave a traditional IRA behind, the beneficiary will also inherit the tax burden. Whether they decide to take it as a lump sum or spread the payments out, the amount they receive will be taxed at their current rate.
But with the Roth, taxes have already been paid, and as long as you have owned the account for longer than 5 years, that money is there for your beneficiary tax-free.
Now that you understand the basics, how do you get started? The easiest way to open a Roth is with a financial advisor, as they will guide you through the paperwork and investment options for your account. If your parents have an advisor, it is worth seeing if they can open an account for you (and charge the management fee to your parents) or look for an advisor who doesn’t require an account minimum to work with them.
If you prefer to open one on your own, it is not impossible, and if you’re a little financially savvy, a google search will take you in the right direction. If you are going to DIY it, I encourage you to consider and compare the potential fees. Some custodians will charge annual fees, and you must also be aware of the hidden fees and expense ratios of the funds you decide to invest in.