You're young. You're earning a bit of money. You know you need to start saving for retirement. So what's the easiest way to get started?
One of the best vehicles for retirement savings for millennials is a Roth IRA, which is a type of account that offers a great selection of investment options and tax advantages. You contribute to a Roth with money that's already been subject to income tax, but when you withdraw it in retirement, everything you've earned in the fund is tax-free. In comparison, you don't pay tax on 401(k) or traditional IRA contributions until you take out the money in your later years. Both have benefits, but there are reasons you might particularly want to consider a Roth while you're young.
It's easy to open a Roth IRA through most popular online brokerage firms, and you don't need a lot of money to get started. (See also: 5 Retirement Accounts You Don't Need a Ton of Money to Open)
Here are some reasons why a Roth IRA is an essential part of any millennial's investment plan.
If you work for a company, you may be offered a 401(k) plan, which allows you to invest in a variety of mutual funds and deduct any contributions from your taxable income. In many cases, your company will match a portion of any contributions you make.
But these days, an increasing number of millennials are performing a variety of contract or "gig" jobs, rather than working full-time with a single company. A Roth IRA is not tied to an employer, so anyone can invest as long as they have earned income. If you are earning income but don't have access to a 401(k) plan, a Roth IRA may be your next best option.
If you have a 401(k), it's wise to take advantage of it, especially if your company offers a match. But be aware that your 401(k) plan may not offer a wide range of things to invest in, and there may be high fees. This is why many financial planners suggest contributing to a 401(k) up to the company match, and then placing any additional savings in a Roth IRA, which may offer lower costs and more investment choices.
The key feature of a Roth IRA is that any investment gains can be withdrawn tax-free anytime after age 59½. If you are a millennial, this is a big deal — because unless you're making big bucks already, there's a good chance you will be in a higher tax bracket when you are older. This tax advantage is in contrast to a traditional IRA or a 401(k) plan, in which the tax advantages come upfront.
Typically, if you withdraw from an IRA before age 59 ½, you must pay a 10 percent penalty on the withdrawal, plus any income tax. But the one big exception involves qualified higher education expenses.
If you use a Roth IRA to pay for education, and limit your withdrawal to your contributions but not your earnings, there are no penalties or taxes. If you do decide to include Roth earnings in your withdrawal, those funds will be subject to income tax. This is a helpful feature for millennials, who may consider going back to school. Parents can also use a Roth IRA to pay for educational expenses for their children. Keep in mind that money from a Roth IRA could impact financial aid calculations. And of course, any money taken out for college means less money in the account for retirement.
It's not the best idea to withdraw money from a retirement account, because you'll lose out on the potential investment gains from the cash you take out. But, you are permitted to take out your contributions from a Roth IRA without penalty at any time. This makes them potentially useful as emergency savings accounts.
Just remember it's only the money you put into the account, not the gains, that can be taken out penalty-free. When you're young and not earning much, it helps to have funds that you can tap whenever a crisis arises. Just don't get in the habit of using a Roth IRA this way too often; the account is meant for long-term investment gains and will benefit you the most if you leave your money alone to grow. (See also: Using Your Roth IRA as an Emergency Fund — Ever a Good Idea?)
If you are a millennial, it's impossible to know when you will retire. You may choose to retire at age 60, or keep working until you're 100. Thus, it makes sense to have an investment account that will let you contribute for as long as you want.
One of the nice things about a Roth IRA is that you will not be forced to make withdrawals at any time. This is in contrast to traditional IRAs, which require you to begin pulling out money by age 70½. (This assumes, of course, that rules don't change between now and then.)
(Editor's note: An eagle-eyed reader pointed out that any Roth earnings used to pay for education would be subject to income taxes. We've corrected the text to reflect that.)
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