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Retirement Planning: The Roth IRA Is Perfect for Young People

We have established previously that the earlier we start saving the more the rules of compounding will work in our favor (see Retirement planning: the rule of 72). It stands to reason that if these savings were sheltered from taxes they would grow even more.

The Roth IRA is different from a traditional IRA because contributions to it are not deductible and have been subjected to taxation at whatever rate your income dictates. Once they have been taxed, they are NEVER taxed again if conditions are met. Well, for most people, the lowest tax rate they will ever see is when they first start working in their teens and through their early 20's. This means Roth IRA contributions for a young person are either taxed at a very low rate or not taxed at all. And their earnings are never taxed if the money stays in the IRA for at least five years (as long as we can trust the federal government to keep this promise, but that is a different story).

In addition, there are income limits that curb the use of Roth IRA's by single people. That is not generally a problem for a young person starting out. The maximum annual contribution if you are under age 50 and eligible, is $5,500 as long as you have $5,500 in W2 income. See your financial advisor for details.

For a young person, say 20, who is working (only W2 income creates contribution eligibility) the rule of 72 predicts that assuming a market rate of 8% (about the historic rate for the stock market) money placed in the market will be worth about 32 times as much at age 66. So why wouldn't a 20 year old contribute? Paying for college, a car, the joy of finally having some cash to spend are just a few of the reasons. A blending of priorities, formed with the help of parents and other trusted financial advisors (no bankers, please, or you'll wind up in an account paying .25%) will help you decide how much you have available.

If you are not convinced yet that you should contribute at least something to a Roth IRA when you are young this fact should convince you:  A person contributing the max to a Roth IRA from 20-26 and then stopping, if the annual rate of return is equal, will have more money at age 66 than the person who starts at age 26 and contributes the maximum annually to a Roth till age 66. This goes back to the rule of 72 where the 20 year old's contributions are doubling one more time than the 26 year old contributor's money can if the money compounds at 8%. It does not even take into account the young person's lower tax rate on contributions.

For parents and grandparents the trick is creating eligible income for their children and grandchildren under the age of 16, respectively, who ordinarily wouldn't be working, and this is where business owners have an advantage. Without going into specifics, business owners often put their children on the payroll to create W2 income. They can then match that income in a Roth IRA.

 

The above should not be considered financial advice nor is it intended to be a complete discussion of the subject.  Consult your own financial advisor to discuss your personal circumstances.

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