The sooner that you start saving for retirement and the more time you have to save for retirement the greater the likelihood that you will have a larger nest egg. Young professionals—aka Millennials in their 20s and 30s—who decide to start saving for retirement can do so in a variety of ways and accounts.
This article focuses on why a Roth IRA is ideal for young professionals.
Financial Challenges for Millennials
Most Millennials are still becoming established in their careers so their incomes may fluctuate. And though they may be in a lower tax bracket, those who are single with no children may pay more of their income percentage-wise since their filing status offers few deductions and exemptions.
On the other hand, young professionals who do decide to get married and start a family incur expenses such as wedding costs, larger living space, more vehicles, childcare costs and other expenditures.
And we haven’t even mentioned repaying college loans.
This puts most Millennials today in in the part of life when their income is most unstable, they are taxed heavily and their expenses are high from paying down debts. So when it comes to saving for retirement, Millennials need a way to save for retirement that will allow them to have great flexibility and tax advantages.
Roth IRA Flexibility
A Roth IRA may be the answer for Millennials. A young professional can go online and open up a Roth IRA in a matter of minutes. Whenever they choose, they can contribute money to it: up to $5,500 per year or up to their taxable income for that year, whichever is smaller. Money in a Roth IRA grows tax-free and can be withdrawn tax-free.
Roth IRA Tax Advantages (and One Disadvantage)
Unlike most other retirement accounts, with a Roth IRA a Millennial can make tax-free withdrawals at anytime. This is huge, because withdrawing money from most other retirement accounts before age 59½ will incur a 10% tax penalty, along with income tax to pay on the withdrawal amount.
Contributions (or the amount equal to them) can be taken out at any time. If the money that was contributed to the Roth IRA has any earnings like interest, dividends or capital gains, the equivalent of this amount can be withdrawn penalty- and tax-free after five years if you are either age 59½ or meet certain special criteria.
These criteria include life events such as becoming a first-time homebuyer. When Millennials go to purchase their first primary residence they can withdraw up to $10,000 of earnings tax-free.
One point on the other side: A Traditional IRA will provide an instant tax deduction that you don’t get with a Roth because your taxable income is reduced by the amount of your contribution.
However (back to tax advantages): The big Roth payoff is when you retire because both your contribution and all the money it has earned over the years can be withdrawn completely tax free. With a Traditional IRA, you get the deduction going in and no taxes until you retire, but then both the original contribution and all its earnings will be taxed at your current income tax each year. And, from age 70½ on, you will be forced to make annual required minimum distributions (RMDs) that will raise your taxable income whether you need the money or not.
Investing for a Roth: Don’t Buy Bonds
OK, you’re sold on opening a Roth IRA. But that’s just the beginning. Now, what do you invest in? I personally am not a big fan of bonds for Millennial portfolios; equities and equity mutual funds are a better choice. Here’s why.
Ride the Market Seesaw
The greatest advantage a investor has on his or her side is time. Millennial investors in particular have the time to ride out the stock market’s up and down swings. There will be years in the coming decades that will see bear markets with down years, of course; but over the long-term so far in history—I’m talking decades, which twenty- and thirtysomethings have—the stock market and stock prices have appreciated consistently.
Stocks Have Higher Returns
Since the inception of the stock market, equities have returned over 8% annually to investors. Since 1988, the S&P 500 index has returned investors 7.4%—and those years included the dot.com crash and the great recession of 2008.
Stocks have greatly outpaced the rate of return on bonds, both government and corporate, which often have had trouble beating inflation. Investing is for the long-term, and that is why it makes sense to have your investment portfolio heavily weighted in stocks and stock mutual funds that earn almost 8%, rather than 4% or less per year with bonds and bond mutual funds.
While many Millennials may not be comfortable riding out the stock market’s gyrations, those who can will be well rewarded by having a large portion of their investment portfolios allocated to stocks and very little in bonds. At least in the beginning.
Later in life, Millennials can start to shift to more income-oriented vehicles. But for now, take advantage of the decades ahead to invest early and often, in ways that reap the benefits of the stock market’s long-standing historical rates of return.