If you’re like me, your 20s are a scary time because of all the decisions you have to make. Sure, there are big life choices in every decade, but for some reason the ones you make in your 20s seem more intense and permanent. What are you going to study in college? What job are you going to pursue? Where are you going to live? Who are you going to marry? The weight of these decisions seems to make the things we struggled with as teenagers (Does he / she like me? Am I going to take Honors Math?) and the things we will struggle with as 30 and 40 somethings (Which house do I want? What school district do I want my kids in?) seem trivial by comparison. I’m here to tell you some good news. You can literally avoid a million dollar mistake and knock years off your retirement date if you follow one simple step in your 20s: Max out your Roth IRA.
What is a Roth IRA? It Sounds Intimidating…
Senator William Roth got this idea that workers should be able to save for retirement without having to plan for what future tax rates would be. He set up a type of account where the money you put in will grow tax free and be available for withdrawal tax free when you retire. Basically it’s the only vehicle in existence that allows the owner to never pay taxes again on any income whatsoever. The Roth IRA is the most powerful tool available to individuals in the US for retirement planning. It is quite similar to the Traditional IRA in that you can make up to a $5,500 contribution every year (as of 2015). However, instead of being able to deduct your contribution from your taxes and save some money upfront as with the Traditional IRA, you get to not pay taxes ever again on the Roth IRA. Hence, if you are expecting to have high taxes in your life and save a lot of money over time, the Roth IRA is a powerful tool of wealth building. All you have to do to shield your money from taxes forever is follow the rules set up by the government.
You can contribute to one if you have low enough income in an attempt to keep this benefit away from high income earners. So if you make under $116,000 a year, you can contribute to one of these accounts. If you make more than that, you might still be able to take advantage of one through what’s called the Backdoor Roth IRA contribution. It’s a real pain in the butt but you might want to take a look into it. If you make that much money a year you should be able to find a reasonably priced accountant to help you do it. You can also call big investment companies like Vanguard and Fidelity that will help guide you through the process.
Where Do You Get $1 million When You’re Only Contributing $5,500 For 8 Years?
Good catch, yes contributions of $5,500 a year for 8 years only add up to $44,000, so what gives? This is where non math and non finance people should really pay attention. Because of compound interest, your money grows exponentially over time. That means it’s not like you invest the $5,500 and it earns 1% of that forever. Rather, with stocks and bonds you can reinvest your proceeds and watch the interest and dividends you received earn a return as well even though it’s not your original contribution. That causes an investment account to multiply instead of just add up gains. Suppose we invested the Roth IRA max contribution of $5,500 a year during our 20s and then left it alone until we retired at 65. I’m going to assume that you start making contributions right out of college at 22 years old. I’m also assuming you invest in a broad stock market index fund and you get an 8% annual return, 2% below what the S&P 500 has delivered over the past 40 year period. How much would we have? Check out what happens below:
That’s right. The example I picked above gives you just over $1 million in retirement to enjoy yourself. This is all from measly $5,500 contributions for an eight year period of time and then forgetting about it and led it ride.
Don’t Make the Million Dollar Mistake
You should have a Roth IRA. Everyone who has a job should have one. Too often young people ignore retirement planning until theirs 30s or 40s and at that point the power of compound interest has fewer years to work. A $1 invested in your 40s brings a fraction of the future wealth that a $1 invested in your 20s does.
Where can you open a Roth IRA? Anywhere. Vanguard, Fidelity, Schwab, your local bank, a financial advisor you trust, almost anyone involved in the money business can help set one up for you. They will charge you fees so be wary of that. Don’t work with anyone that wants to charge you more than 1% to manage your Roth IRA. There are plenty of great options below that price level for help.
Start saving now in that Roth IRA and retire a millionaire. The reason you don’t see more people doing this is because more people are concerned with nights out on the town and new EDM events in their 20s. Thinking about saving, investing, and retirement usually hasn’t entered the picture yet. So buck the trend and set up a Roth IRA today. You might just become a future millionaire.