Over the years, we've have covered many topics in this column that we feel are important to our youth, including the benefit of saving money, the value of creating a budget, managing risk, and the importance of creating a financial system.
We have made a commitment to try to educate as many young people as we can reach about the benefit of starting to save for retirement as early as possible, one of the most obvious being opening a Roth IRA. Since summer is the time when most kids start working or return to their summer jobs, we thought now was a good time to focus on that topic, with the hope that many of you will hand it off to your high-schoolers, so they, too, can understand the benefits of opening a Roth IRA.
So, let’s get started.
A Roth IRA is an individual retirement account that offers tax-free growth on after-tax contributions. In other words, the owner of a Roth IRA does not get a tax deduction for his or her contributions, but all future withdrawals from a Roth, of both contributions and earnings, are tax-free, provided those distributions meet certain requirements. A Roth IRA is one of the most tax-advantaged retirement tools for a young person. Think about a farmer, who has just a handful of wheat seeds that weigh less than a pound. The farmer plants those seeds, lets them grow, and then harvests them at the end of the season. A few ounces of inexpensive seed turns into hundreds of pounds of valuable wheat.
Anyone can contribute to a Roth IRA as long as he or she has earned income from a job and has income below certain specified levels. However, contributions are limited to either $5,500/year if a person is under 50, ($6,500/year if a person is over 50) or the extent of earned income. So, if a summer job pays $3,000 and a kid does not “earn” any other money during the year, then the most he or she can contribute is $3,000 that year.
A Roth IRA is a great saving tool for young people, for many reasons. Young people are almost always eligible to make contributions (I have never met a teenager who exceeds the income limits); and for the same reason, those young people typically do not need the tax deduction that would otherwise be available for Traditional IRA contributions, as they are usually already in the lowest tax brackets. But most importantly, Roth IRAs provide a mechanism to help our youth take advantage of many years of tax-free earnings.
Roth IRAs are also somewhat flexible. It is usually a pretty reliable rule that it is best not to withdraw from a retirement account until age 59 1⁄2 or later. But young savers often require large amounts of money for certain things—buying a car, paying for college, putting a down payment on a house—and because the contributions to a Roth IRA have already been taxed, they can be withdrawn at any age without having to pay an additional tax or penalty (which is why they are more flexible than Traditional IRAs). On the other hand, an account must be open for a minimum of five years and the owner must be at least 59 1⁄2 years old to withdraw earnings both tax-free and penalty-free. However, there are exceptions to these rules for disability of the account owner, first-time home purchases and expenses related to higher education.
I understand that, often, trying to convince a teenager to do something that will help them in 50 years is impossible. So, we believe that quantifying the possible benefits helps quite a bit.
Let’s assume at age 15, Suzy (our example saver) can expect an average rate of 6 percent return on her investment over the years, with a plan to contribute $4,000 a year to her IRA. When she is 30, based on her plan to contribute $4,000 a year, her Roth IRA will likely be worth almost $110,000. When she is 50, it will be $550,000. At 65—get this—nearly $1.5 million. That's something that should get your kid's attention, that over those 50 years of saving, their total contribution of $200,000, with compounding returns, could turn into $1.5 million! Alternatively, if they were to wait until they are 30 to start contributing to a Roth IRA, their $4,000 per year would only turn into about $375,000, based on the same assumptions. The life lesson here is that a little dedication now will pay off big in the future. By starting early, our youth have time on their side.
One last note about Roth IRAs is that, unlike the Traditional IRA, which has required minimum distributions (RMDs) beginning at the age of 70 1⁄2, there is no RMD on a Roth IRA. Not only that, but remember: even if you take a distribution, if done correctly, it is all tax-free!
Here at Gary Scheer, LLC, we feel fortunate to be able teach the importance of financial responsibility to our community, and hopefully, the children in our community as well.