The greatest investment opportunity ever invented for young people is now 21 years old. First available in 1997, a Roth IRA is an investment account into which a person puts after-tax money. This is different from most conventional retirement accounts (401k, 403b, SEP, SIMPLE, or tradtional IRA plans) that take pre-tax contributions.
To parents of young adult children: if you’re wondering what’s the best way to offer a young adult a way forward in life it’s hard to imagine more bang-for-buck than a Roth IRA.
What makes this so important for young people is that it brings together two of the most powerful forces in investing: compounded returns and income tax avoidance. Young investors have the time horizon to let their money grow, and probably aren’t paying much in taxes now.
Let’s deal with those two factors in order.
The limit for contributing to a Roth IRA for tax year 2018 is $5,500. For 2019 it rises slightly to $6,000. In order to make this contribution, a person must have earned income from wages or self-employment. Dividends, interest and capital gains do not count. You have until April 15 to make a Roth IRA contribution for 2018 income. Of course, you could also go ahead and make your 2019 contribution right now as well.
Let’s talk compounded growth first. Here’s where the fun starts.
An investment made by a 22 year-old of $5,500 for 2018, and of $6,000 per year going forward until age 60 will grow to $1.7 million at a compounded annual return of 8.7%. That’s conservative. The total return of the US stock market from 1926-2017 (just 92 years) is 9.9% annualized. 8.7% happens to be the worst 40 year period in US market history (1929-1968).
Investing simply has never been cheaper or more efficient. Several major brokerage firms like Schwab, Fidelity & Vanguard will let you buy the entire US stock market at zero management or transaction fees.
So that’s compounded growth. Now let’s look at tax avoidance.
A 22 year old entering the work force this year is likely not going to be paying much in income taxes. If a single taxpayer makes $45,000 in wages, the likely federal effective tax rate is barely 8% (your mileage may vary, but this is a good working estimate). Each state has their own system, and Maryland’s is not particularly generous to working people, so throw another effective 7.4% on the fire. 15% isn’t nothing, but it’s likely to be the lowest total taxation a middle-class person will face in her life.
A Roth IRA is particularly attractive at low current tax rates. A traditional IRA offers a tax deduction now in exchange for paying taxes later. The Roth IRA stands that logic on its head: after-tax money goes in now so that future earnings come out tax free.
Even with alleged tax reform, middle-class and higher families are paying effective tax rates of 30% or more (federal and state) on their net income. This figure is likely higher if you live in a high-tax state like my own Maryland and have lost the ability to deduct state and local taxes. There is little in the political debate to believe that tax burdens on middle-class families will be significantly lower in future decades.
Finally, to parents of young adult children: if you’re wondering what’s the best way to offer a young adult a way forward in life it’s hard to imagine more bang-for-buck than a Roth IRA. A gift to open a Roth or contribute to one will help pull them to financial independence more effectively than virtually anything else. It is a gift that will pay for decades to come.
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