June 22, 2021
The Roth IRA was designed for and is typically thought of as just a retirement account, however its many features make it the Swiss army knife of investment accounts. The tax advantages are well documented. When you invest in a Roth IRA, you fund it with money you have already paid taxes on (after-tax). That money grows tax free and when you take it out after age 59 1/2, it all comes out completely tax free. For 2021, the contribution limit for those under 50 years of age is $6,000 per year. Those over 50 can contribute an extra $1,000. Due to income limits, those with higher incomes may not be eligible to contribute to a Roth IRA. You should check with your tax advisor to make sure you are eligible to contribute to a Roth.
One of the great benefits of a Roth is that any contributions you have made can be withdrawn at any time, tax and penalty free. This opens up a world of possibilities in one’s financial plan, particularly with young adults entering the work force. In terms of a savings cadence, college grads should place priority on contributing to their company’s 401(k) up to the company match and ideally into a Roth 401(k) if offered. Having all of their extra money go into their 401(k) may not be the best option since you lose a lot of flexibility in accessing the money in the future. Next, they should have about one months’ worth of bills set aside in a savings account. After those bases are covered, the Roth IRA is the perfect next step for a young adult.
Since a Roth IRA contributor has the ability to take contributions out at any time, it can be used as an emergency fund. However if you plan on accessing your Roth IRA contributions before age 59 1/2 , those investments within the Roth should be invested very conservatively while being earmarked as an emergency fund. Once an investor regains financial stability, they should add more to the savings account until it reaches six months’ worth of expenses. Those that are more conservative or have concerns about their employment should save 12 months’ worth of expenses for an emergency.
For most young adults starting out, their income is fairly low, but should grow as their careers take off. Many will want to get married, buy a house, and have children. Since you are limited in how much you can add to a Roth each year, funding the Roth early can make a large difference later in life. An investor who contributes $6,000 per year for 10 years has $60,000 that can be withdrawn with no taxes or penalty. This can be used to pay for a wedding or a down payment on a house and they would still have the earnings left in the account for retirement.
Roth contributions can be used towards college savings as well with an additional benefit. The gains can also be used towards college expenses without incurring a penalty, however you will be taxed on that portion of the withdrawal. An investor who has contributed for 20 years will amass $120,000 in contributions that can be used towards college. At a contribution of $6,000 per year and a 6% rate of return, the total account will be $220,714, with earnings of $100,713 that can also be used towards college with no penalty, but will be taxed. It is prudent however to keep the profit portion in the Roth and use that towards retirement. For this example, we have assumed a constant contribution of $6,000, and as the allowable maximum contribution amount has been going up over time, this savings amount will be even greater.
Another potential benefit for young adults is the ability to withdraw up to $10,000 of Roth IRA earnings, in addition to contributions, towards the purchase of their first home without paying a penalty or taxes. To qualify as a first-time homebuyer, you or your spouse must not have owned a principal residence within the last two years. Remember that IRAs are individual retirement accounts, so you and your spouse may both be allowed to withdraw up to $10,000. Another requirement to withdraw the earnings tax and penalty free is that you must have owned the Roth IRA account for at least five years. If you started your Roth IRA less than five years ago you will owe income tax on the earnings.
As you see, the Roth IRA is indispensable as a tool in one’s financial plan. Not only is it an ideal retirement savings vehicle, but it can be used for emergency funds or to achieve various life goals such as a wedding, owning a home, or as a source to fund college savings. Having flexibility with your retirement savings is crucial. As we all know, life happens. Making wise choices early in life can make financial decisions easier down the road. Saving in a Roth IRA as early as possible is one of those smart choices.
As always, it is best to consult with a professional financial planner to ensure you are on a successful path towards retirement.
This Forbes article has been updated from the original, which was published Nov 22, 2019.
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